Friday, March 30, 2012

Health Care Stocks in a Maelstrom

Following up on yesterday's note on my meeting with Zimmer management:

I went to go hear Barclay Capital's health care analysts Tony Butler and Ying Huang yesterday.

I won't go into their specific stock picks other than to say that they are cautiously optimistic on their group.

 Big pharma offers good dividends, low valuations, but meager new drugs in the pipeline.

Biotech stocks traditionally trade on news of a new drug discovery, which by definition is basically defies traditional stock valuation work. Still, several biotech companies have some exciting new drugs in the testing phase, which could mean outsized returns if everything plays out.

What I wanted to mention today was their thoughts on the current debate in Washington on the fate of President Obama's health care plans.

The Supreme Court is not expected to announce their ruling on the legality of so-called Obamacare until June, but their decisions could have a wide-ranging impact on our society not to mention health care stocks.

While not necessarily endorsing their views, I thought I would share some of the comments that Messrs. Butler and Huang made yesterday:

Despite the fact that 80% of the pharmaceutical drugs sold in the United States are generics - compared to just 30% in Europe - US pharmaceutical companies still enjoy margins and profits that most industries could only dream about.

The pharmaceutical industry argues that the wide margins they make on branded drugs are necessary in order for them to fund very expensive research and development efforts.

The reason that Europeans use more branded drugs than generics is simple: European governments put a cap on what manufacturers can charge.  Given the choice between a branded or generic drug, most would choose the branded if prices are essentially the same, which is the case in Europe.

However, the European price controls have lead European drug manufacturers to move much of their R&D efforts offshore, largely to the United States. 

If Obamacare is struck down, it seems likely that the next step the government will take will be to try to impose some sort of price controls on pharmaceutical drugs.  The rate of growth of health care costs in this country is simply too high.

It seems logical, then, that price controls in this country will lead to either drastic cutbacks in R&D efforts in the U.S., or possibly moving R&D efforts to other parts of the world such as Asia.

The effect on the valuations of the pharmaceutical stocks could be significant.  The reason that European pharma sells at a significant discount to U.S. companies boils down to the superior R&D efforts at U.S. manufacturers.  

Absent a robust drug development effort, then, US pharma becomes nothing more than distributors,  meaning serious declines from current valuation.

 They also made the following points regarding health care providers:

If Obamacare is ruled unconstitutional, the US health care system is faced with the problem of how to deal with the large group of citizens that do not have health care insurance.

Bad debt expense is an enormous problem for most hospitals.  At some large metropolitan hospitals, bad debts can run as high as 20% of revenues.  This is not saying that the uninsured are deadbeats; no, it is simply that they do not have the funds to pay for medical treatment or insurance.  

To put it bluntly:  If Obamacare passes, it will be a huge benefit to hospitals, and to the hospital stocks that are publicly traded.  On the other hand, HMO stocks will suffer, since their main advantage of lower costs goes away.

If Obamacare is struck down, hospitals are tanked, while HMO stocks soar.

Yesterday HMO stocks were among the best performers in the market on a generally down day.  The market's verdict seems to be that the Supreme Court is leaning towards striking down Affordable Health Care Act.

It should be an interesting time between now and June, when the Supreme Court's decision is actually announced.

Thursday, March 29, 2012

Rough Times Ahead for Health Care Stocks?

The Supreme Court yesterday ending three days of oral arguments discussing the constitutionality of President Obama's healthcare initiative passed by Congress a couple of years ago.

Here's how the Washington Post described the debate this morning:

The Supreme Court closed an extraordinary three-day review of President Obama’s health-care law Wednesday, with its conservative majority signaling that it may be on the brink of a redefinition of the federal government’s power.

Justices on the right of the deeply divided court appear at least open to declaring the heart of the overhaul unconstitutional, voiding the rest of the 2,700-page law and questioning the underpinnings of Medicaid, a federal-state partnership that has existed for nearly 50 years.

The Court will apparently not render a decision until June, but their ruling could change the way health care is delivered in this country.

However, the health care industry has already been undergoing significant changes in the past few years.

Health care stocks used to offer investors a "safe haven" due to their predictable revenue growth and fat profit margins.

However, as the pressures to slow the growth in healthcare expenses in this country have grown, the industry is under tremendous pressure to deliver the same kind of growth and profitability that investors have come to expect in the past.

I was reminded of these trends yesterday, when I had the chance to hear from management of Zimmer Holdings (ticker: ZMH).

Zimmer is one of the largest manufacturers of orthopedic implants (hips, knees, spine, trauma and dental) as well as related orthopedic products in the United States.

The company had been part of pharmaceutical giant Bristol Myers for many years before it was spun out in 2001.

Initially Zimmer was a stock market favorite.  Investors loved the fact that its products have a very favorable demographic tailwind as well as their ability to raise prices at a rate of +5% a year.  At the same time, operating margins at the company remained in the neighborhood of 25%, which allowed for a very steady growth in earnings per share.

For the first 6 years of its independent existence from Bristol, Zimmer stock was a home run, rising nearly +200% compared to a gain of just +24% for the S&P 500 during the same period.

But then reality, and the recession, hit.

Since its peak in the spring of 2007, Zimmer has fallen by nearly -30% vs. a loss of just -5% for the S&P 500.

The problem that the Zimmer has faced - as well as other orthopedic manufacturers - is that hospitals and doctors have become more cost conscious.  Hip replacement technology, for example, varies only in minor details between products, and often the more expensive solution is not necessarily the best for the patient.

The orthopedic device industry now face the prospect that Medicare - the largest purchaser of orthopedic devices - will now start posting prices that it will pay for products on the internet.

Although Zimmer yesterday downplayed the significance of this development - claiming that most hospitals already routinely share cost information - this will be another headwind the company will face in coming years.

And so in yesterday's meeting Zimmer management spoke mostly of cost-cutting. They are targeting cost saving of at least $400 million (roughly 6.5% of current expenses) between now and 2016.  Sales growth will come mostly from acquisition - the days of organic growth seem over for now, at least.

The investment case for Zimmer rests largely on your view of the economy.  When times are good, people are more likely to go for orthopedic procedures.

But if economic growth remains sluggish, Zimmer's stock could also struggle in this new world of American health care.

Wednesday, March 28, 2012

Time To Overweight Financials?

There is a time for everything, and a time for every purpose under heaven.
                                                                      -Ecclesiastes 3:1

In 2011, the key to outperforming the S&P 500 was how you were positioned in the financial sector. 

Despite a fourth quarter rally, stocks in the financials were easily the worst performing sector in the market.  While the S&P gained slightly more than +2% last year, financials fell more than -18%.

But as the Bible reminds us, there is a time for everything, and 2012 might be the time for the financial sector.

The problems for the group remain daunting, including:
  • Loan growth remains anemic. 
  • The small difference in yields between short maturities and intermediates hurts bank profits. 
  • Low bond yields hurt insurance company profitability.
  • Corporate underwriting activity has increased, but competition is fierce, and pricing is under severe pressure.

Oh, and that little problem with credits in the euro zone could resurface and overwhelm the banking system.

And yet a case can be made that most of the problems in the financial sector are already reflected in the prices of the stocks.

The money center banks, for example, are trading at the low end of their historic price/book range. The same is true for the shares of the property/casualty insurance sector, where nearly all of the stocks are trading below book value.

Even Berkshire Hathaway - which is at its heart the world's largest reinsurance company - is trading at its lowest level in decades.

Earlier this year we added to positions in the financial sector in institutional accounts where performance relative to the S&P 500 is a crucial measure of success.

We had been largely underweight the group for most of 2011, but the risks of maintaining such a bearish position were too great.

The financial sector remains unloved among the Wall Street strategist group.  Most are recommending a continued underweight, citing all of the factors I mentioned earlier.

But cheap valuations and bearish sentiment usually mean opportunity, and I think financials fit that description to a T right now.

Tuesday, March 27, 2012

Question Authority

State Pensions Missed the Boat
Earlier this month I wrote a couple of pieces on Random Glenings criticizing the investment allocation decisions of the state pension boards of California and Massachusetts.

Specifically, I focused on the fact that the boards had been constantly reducing their exposure to the US stock market over the past few years in favor of either fixed income or alternative investments. This despite the fact that equity valuations versus bonds haven't been this attractive in 40 years.

Not surprisingly, both states now face significant pension shortfalls, as recent returns have not kept up with actuarial assumptions. 

So imagine my reaction when I read in this morning's New York Times that there is a serious proposal afloat to have state pension boards run retirement assets for workers:

As growing numbers of baby boomers face retirement with inadequate savings, some state officials are considering a novel proposal to rebuild America’s ailing retirement system — having state pension funds run retirement plans for companies. 

Fortunately, some other observers have pointed out that:

 Not everybody sees it that way. The big public pension systems have been criticized in recent years for, among other things, underestimating the cost of providing conventional pensions and failing to anticipate market crashes that have left local taxpayers to bail out investment failures. Participating cities and taxpayers are rebelling in some places but have no legal way to drop out of state-run plans.

Back to my thoughts on the boards.

Here's what I wrote on March 15:

Here's a report from CNBC last September, right before the market started to rally:

The California Public Employees Retirement System is as worried as any investor about the uncertainty in the U.S. and Europe.
That's why Calpers, as it is known, is a "longterm trader" that is playing down equities, Chief Investment Officer Joe Dear told CNBC Wednesday. He indicated the Calpers portfolio is "underweight" equities by about 4 percent from its typical allocation
When you go to the CalPERS website, you see that just 48% of their portfolio is invested in public equities.

Meanwhile, 22% of the fund is invested in either "income" or "liquidity", both of which are essentially yielding less than 2%.

You would think that CalPERS would have investments with a very long term time horizon.  Most of the beneficiaries of the plan will be drawing their benefits for many years, but the yearly outflows are only a small fraction of the overall fund size.

But instead the group is investing with their eyes fixed firmly in the rear view mirror.  They have investments that will guard against inflation - with virtually no signs of inflation on the horizon.  They have huge investments in real estate and private equity, whose eventual returns are totally unknown.  They have hedge funds which, as a group, are probably barely earning their fees.

But common stocks - boring, large cap stocks trading at the most attractive level of valuation to bonds in more than 40 years - are getting a cold shoulder from the group, since they have been disappointing performers in the past decade.

This decision is not only likely to hurt returns, but also will cost the taxpayers of California. At a time when public services are being cut in many towns around the state, California municipalities are being forced to pony up more funds to keep the public pension plans funded.
This cautious investment stance is consistent with the state of Massachusetts, by the way, and probably most other states as well.

The decision to place money with the so-called "smart investors" who run hedge funds and private equity pools never seems to be questioned, despite a paucity of evidence that would warrant continued allocations to alternatives.

If nothing else, the fact that nearly $2 trillion has been placed with non-traditional asset managers almost certainly means that returns will be subpar for most of the group, especially after the enormous fees these funds charge.

And are these managers truly superior investors compared to, say, index funds?

Well, here's a piece from yesterday's Bloomberg that would suggest that once again the so-called smart money has found itself on the wrong side of the market action:
Hedge funds trailing the Standard & Poor’s 500 (SPX) Index for the last five months are giving up on bearish bets and buying stocks at the fastest rate in two years. 

A gauge of hedge-fund bullishness measuring the proportion of bets that shares will rise climbed to 48.6 last week from 42 at the end of November 2011, the biggest increase since April 2010, according to data compiled by the International Strategy & Investment Group. The Bloomberg aggregate hedge fund index gained 1.4 percent last month, lagging behind the Standard & Poor’s 500 Index by 2.65 percentage points.

Monday, March 26, 2012

Focus on Fundamentals, Not Predictions

Famed Fidelity mutual fund manager Peter Lynch used to say that if you spent 10 minutes a year studying the economy, that was 10 minutes too much.

From 1977 until 1990 Lynch managed the Magellan fund for Fidelity.  During that period Magellan averaged an incredible +29.2% annual return.

Peter Lynch's success was largely due to his relentless focus on fundamental research.  He would spend hours listening, learning and analyzing stocks, looking for opportunities that others had overlooked.

However, as much as Lynch believed in fundamental research, he disdained investing based on broad economic or market themes. 

As he once wrote in his "20 Golden Rules for Investing":

There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of newscasters. Sell a stock because the company's fundamentals deteriorate, not because the sky is falling.

Nobody can predict interest rates, the future direction of the economy,or the stock market. Dismiss all such forecasts and concentrate on what's actually happening to the companies in which you've invested.

Over the years I have come to fully appreciate the wisdom in what Peter Lynch was saying.

Economic forecasts are notoriously unreliable, and usually wrong.  Moreover, even if the forecast is actually correct, it offers little help in developing a successful investment strategy.

I was reminded of this again when I read Floyd Norris's column in Saturday's New York Times.

Norris points out that while the performance of the economy has been relatively poor since President Obama took office in early 2009, the stock market has turned in one of the best returns of any American president's tenure in office (I have added the emphasis):

From the fourth quarter of 2008 through the final quarter of 2011, the American economy grew at an annual rate of just 1.4 percent. Of course, the economy declined during the first two quarters of 2009, reflecting the financial crisis and recession that began before Mr. Obama was elected, and has since recovered all of the decline and more. Nonetheless, over comparable periods, the economy performed better in 21 of the previous 24 administrations. 

But since the presidential inauguration on Jan. 20, 2009, the stock market has risen at an annual rate of 16.4 percent, even after adjusting for inflation. That is better than all but four previous administrations.

Norris's piece is largely focused on the President's reelection bid, and what the divergence between the economy and stock market might mean.

To me, however, the larger point is this:

If I had told you in early 2009 that economic growth would average only slightly better than +1% for the next three years, you might have concluded that stocks should be avoided.

But, as the +16.4% compound return indicates, this would have been the wrong decision.

And so it is true today:  no one knows what the growth in the economy might be in the months ahead, or what the direction of interest rates is likely to take.

But the relative valuation of stocks - based on the fundamentals - suggests that stocks continue to offer the best opportunities to investors.

Friday, March 23, 2012

Five Contrarian Investment Plays for 2012

As I mentioned yesterday, I've been attending an "Asset Gathering" conference here in Boston. 

Throughout the day I was struck by the near-uniformity of opinions when it came for the outlook for the markets.

In addition, nearly all the speakers shared similar themes when it came to asset allocation.

It is axiomatic in the investment world that in order to make money you have to have a opinion that is different than the consensus. Consensus views are usually already priced into the markets; if you want to make money, you have to wager that the consensus has it wrong in some respect.

Here are five topics that were discussed in great detail.  It seems to be a pretty safe bet that at least one, if not more, of these ideas will prove to be wrong:

1. Interest Rates Are Headed Higher.  Ever since 2002, strategists and economists have insisted that bond yields are too low, and the next move for rates is higher.  Interest rates, of course, have done just opposite of what every one forecast.  Maybe they'll be right this year.

Interestingly, in response to a question from the audience, no one on the panel discussing asset allocation thought you should be selling bonds now, even though they all thought that rates were headed higher.

2. Stocks are Due for a Correction of -5% to -10% fairly soon, probably in the second quarter.  Much of this sentiment is based on the strong move that the markets have had since last fall, and not so much on any fundamental data.

3. There is no value-add in active management of domestic stocks.  Interestingly, this sentiment is so widely accepted at a time when the correlations between stock price movements has been falling rapidly.  This should mean that a good manager will increasingly be able to find opportunities in sector or stock picks, but no one seemed to believe this.

On the other hand, all seemed to agree that active management of foreign stocks - including emerging markets - makes sense.

4. Alternatives should play an increasing role in client portfolios.  What's interesting about this widely-held view is that no one ever presents any data that shows that investing in private equity, hedge funds, etc. actually was a money-winner.  This is sort of the "Tinker Bell" approach:  Clap if you believe.

5. High Yield and Non-Dollar Denominated Bonds are Good Alternatives to US Treasurys.   However, if the economy is really on the precipice of another downturn - as several speakers suggested - junk bonds will fare very poorly.

And buying bonds of other countries carries significant currency risk - a rising dollar will wipe out any possible yield advantage from foreign bonds.

Every speaker agreed that "educating your client" would be a very important for success in the investment management business in 2012.

I might suggest that the education efforts could be aimed at the members of my industry as well.

Thursday, March 22, 2012

When Will the Retail Investor Return to the Stock Market?

I've been attending "The Asset Gathering Conference" being held here in Boston.

Sponsored by the brokerage firm UBS, the conference features speakers from such large asset managers as Franklin Resources; Fidelity; MFS; and State Street Global Advisors.  In addition, several consulting firms are making presentations, including Boston Consulting Group and McKinsey & Co.

UBS has held this conference annually for the past several years, and I've always found them to be informative.

The mood at this year's conference is relatively somber, in my opinion.

All of the companies are struggling to offer products that will attract new investments.  However, most investors are fairly discouraged by the meager returns from the stock market over the past decade, and are mostly focused on income and safety.

Last year 80% of the mutual fund inflows went to just three companies:  Vanguard; Pimco; and Fidelity.  Moreover, the vast majority of these inflows went to just five mutual funds.

Investors are interested in either index funds (Vanguard) or fixed income (Pimco);  actively managed equity funds, especially those investing in the US, continue to see outflows, regardless of their relative performance.

According to the speakers that I have heard so far, investors are more interested in guidance than relative investment performance.  Target funds - where fund complexes offer funds that adjust asset allocation as a selected target date approaches - are the third most popular product offering, after bond funds and emerging market equity funds.

So the question is: When will the retail investor return to the US stock market?

Unfortunately - and this may explain the somber mood of the audience - history suggests that the average investor may shun stocks for longer than anyone would like.

In the 1970's, for example, the market took a steep dive in 1974, but then gradually recovered for the rest of the decade.  According to data from the Investment Company Institute (ICI), inflows into equity mutual funds did not turn positive until 1982, or nearly 8 years after the market had hit its lows.

However, I would argue that today's low interest rates makes avoiding stocks altogether a fairly expensive way to invest your savings.  Inflation is low, but is still running at around 2% or so, meaning that you need to earn more than money market rates to keep up with inflation.

In addition, unlike the 1970's, nearly all workers have been forced to save for their own retirement - pension plans have largely disappeared for all but the public sector.

However, the ICI released data yesterday that indicated an acceleration in outflows from domestic equity funds, despite the more bullish commentary emanating from Wall Street.

The average investor just ain't buying into this rally.

Wednesday, March 21, 2012

The Coming Bear Market for Bonds?

Treasury Bond Yields

When I first started in the investment business 30 years ago, in 1981, bonds had been in a secular bear market for more than 35 years.

As you can see on the chart above, for most of the 1940's bond yields were around the 2% level.  Investment wisdom of the day called for most, if not all, of a typical investment portfolio to be invested in high quality bonds, regardless of the time horizon.

In a way, this was not surprising. Stock market returns had been disappointing for most of the 1930's and 1940's, to put it mildly.  Indeed, a survey done in 1948 indicated that more than 80% of those surveyed felt that investing in common stocks was too risky for the average person.

Bond yields started to gradually move higher in the 1950's, as economic conditions improved and credit demands increased.  However, as inflationary pressures built in the late 1960's, interest rates started to move sharply higher. 

For most of the 1970's, bonds were "certificates of confiscation" since the yields they offered did not keep pace with the high rates of inflation sweeping through the US at the time.  "Real" returns - that is, yields after deducting inflation - were negative for bond investors.

If memory serves, 1981 was the first time that bond investors lost money on a total return basis (i.e. the total capital loss was greater than income received). By 1982, the benchmark Treasury bonds sported a 14% coupon - and traded at a significant discount to par.

As it turned out, of course, early 1982 marked the peak of interest rates in the 20th century.  Bond yields gradually declined for the next two decades, and bond investors enjoyed equity-like returns.

An investor in long maturity Treasury bonds in 1982 earned a compound return of nearly 13% per annum for the next 17 years - a terrific return achieved just by investing in boring government bonds.

Yields have continued to decline for most of the last dozen years.  In a remarkable round trip, we now find ourselves with government bond yields back to the levels of the 1940's.

So what happens next?

It is too simplistic, I think, to simply say that the next leg for interest rates will be higher.  The Fed's announcement that it will be keeping interest rates at essentially 0% until the end of 2014 means that it will be difficult for rates to move sharply higher.

However, it is also true that very few, if any, investors over the last couple of years have ever sustained significant losses from investing in bonds.  Like investors 60 years ago, conventional wisdom still holds that bonds are a "safe" investment for those that want to gradually increase their investment portfolios.

For example, according to Merrill Lynch,  $483 billion has been added to bond mutual funds since 2008.   During the same time period, $38 billion has been pulled from equity mutual funds.

I fear that the surprise for thousands of investors this year might be the discovery that bond prices can also move lower. In particular, retail investors in bond mutual funds might find themselves with significant capital losses that cannot be avoided unless rates return to historic lows.

Moreover, I think it is very possible that small losses in bonds might lead to a massive reallocation from bonds to stocks in retirement and pension plans.  In this scenario, bond investors rapidly sell their holdings in favor of stocks, causing interest rates to rise at the same time that stock prices are rising as well.

In short, I don't believe this is the time to be complacent with positions in bonds.

Tuesday, March 20, 2012

"Portfolio Management is Easy - It's the Research That's Hard"

My wife Christina and I took our daughter Caroline to the University of Virginia (UVA) on Sunday for a visit. Caroline was accepted by UVA last January.

I won't dwell on our visit other than to say that UVA is a terrific place in all respects.

While Caroline has not yet made her final decision, she seems to be leaning toward UVA, and we would be thrilled if that was direction she took.

Caroline spent Sunday evening in the dorms with some of the current students, so Chris and I had the chance to have dinner with a couple of friends of ours that live in Charlottesville.

Our friends moved to Virginia a couple of years ago, and absolutely love the lifestyle.  Interestingly, although Charlottesville is obviously best known for UVA, it is also the home of a number of prominent hedge fund investors, including a guy named Ted Weschler.

You probably haven't heard about Ted Weschler, which is apparently just the way he likes it.

However, Ted and his partner manage about $2 billion from a small office in Charlottesville, and their returns have been spectacular: +1,236% over the last 11 years.

Despite his efforts to keep a low-key profile, Mr. Weschler came to the attention of the financial press last September when he was asked by Warren Buffett to help run Berkshire Hathaway's $52 billion equity portfolio. Weschler will be partnered with another succesful investor named Todd Combs, who joined Berkshire in 2010.

As it turns out, Mr. Weschler is a next-door neighbor of our friends from Charlottesville, so naturally I asked the question:

"What's Ted Weschler like?"

The answer:  He's a very likeable, down-to-earth fellow who just reads all the time.

Put another way, other than the fact that he commutes to Omaha, Nebraska, every week, Ted Weschler lives a very ordinary life.

I'm always struck by how unexciting the lives of most prominent investors tend to live.  While the popular media always focus on flashing screens and rapid-fire trading, the best investors seem to spend months learning and studying before making any allocations of capital.

Buffett, for example, has been described as a one-person learning machine.  His partner Charlie Munger has said that if you put a clock on Buffett's typical day you would find that he spends the vast majority of his time reading and talking to other investors he respects.

It sounded like Ted Weschler spends most of his working days in the same fashion.  He reads, studies, and only occasionally makes investment changes. And, like Buffett, his investment portfolio contains relatively few positions.

Here's how Reuters described the investment portfolio of Peninsula Capital Advisors, Weschler's investment vehicle last fall:

Weschler has overseen a very concentrated portfolio with DirecTV, DaVita, which runs kidney dialysis centers, and Liberty Media ranking among his biggest and most recent holdings.

In total, he held fewer than a dozen publicly traded U.S. stocks at the end of the second quarter, according to his most recent regulatory filing. He is not required to list stocks he may be shorting or otherwise betting against.

Modern portfolio theory teaches that a concentrated portfolio is too risky for the average investor, which I generally agree with.  However, if you have a knack for uncovering hidden value, and are willing to spend the hours making sure you truly understand the companies in which you are investing, a portfolio consisting of just a dozen stocks could actually prove to be the correct strategy.

During our dinner I was reminded of the conversation that I had with a veteran investor years ago.

We were talking about the markets, and I had just mentioned that managing a portfolio in volatile markets can be very stressful.

This investor looked at me and scoffed.

"Portfolio management is easy. With today's technology, all it takes is a couple of clicks with your index finger to make an trade."

"No, what's hard is research.  Finding the right stock or bond takes a lot of work if you are to be successful."

Friday, March 16, 2012

The Real Expense of Safety

This Just Doesn't Add Up!
N.B. The college tours continue:  my wife and I are taking our daughter Caroline to University of Virginia this weekend.  Caroline has already been accepted, but wants to take a final look before making any final decisions.

Accordingly, the next post of Random Glening will be Tuesday, March 20.

Yesterday I questioned the asset allocation decisions of the California Public Employees Retirement System (CalPERS).

Specifically, I noted that CalPERS allocates just 48% of their $220 billion investment portfolio to equities. Part of the remainder is stashed in low-yielding bonds, while the rest resides in "hold and pray" investments in private equity or real assets.

If the latter do not achieve the stated investment goals - which recent history would suggest is certainly a possibility - reaching CalPERS's assumed actuarial rate of 7.50% might be a challenge.

As luck would have it, columnist Steve Syre addressed the same subject in this morning's Boston Globe, except that Mr. Syre was focused on the $50 billion Massachusetts Pension Reserves Investment Trust (PRIT).

According to Mr. Syre, Massachusetts State Treasurer Steve Grossman believes the 8.25% assumed actuarial rate for PRIT is too high.  Instead, Mr. Grossman has proposed lowering the rate to 8%, which will increase the state's pension liability by $1.25 billion.

Fair enough.  But here's the problem:  PRIT has not earned anywhere close to 8% for the last decade, despite the fact that PRIT's relative performance compared to other state retirement plans is around average.

According to PRIT's annual report (found at, here are the fund's total investment results for the year ending June 30, 2011:

1 year:  +22.4%
3 years: +1.7%
5 years: +4.4%
10 years: +6.5%

Ah, you say, but this is in the past.  Going forward, is it not possible that we will see considerably better returns in the next decade?

Yes, I would agree, but only if the investments are focused on areas that offer at least the mathematical possibility of achieving a blended rate of 8%.

So I turned to how PRIT is invested, and here's what I found (all figures as of June 30, 2011):

Domestic equity:   22%
International equity (including emerging markets):  29%
Fixed Income: 19%
Private equity/real estate/natural resources:  22%
Hedge funds:  8%

However, in September 2011, PRIT decided to cut its equity allocation in favor of alternative investments:

As part of a new asset allocation mix approved in August, Mass. PRIM has allocated $1bn each to hedge funds and local currency emerging markets debt, a  new area for the top 10 US retirement system, and cut around $3bn from its equities allocation to fund the new mandates.

PRIM’s global equity allocation will drop to 43% from 49%, specifically cutting international to 17% from 21%, and domestic large-cap equities from 17% to  15%. The retirement system allocated 2% of its portfolio to local currency emerging  markets debt.

In other words, just like California, Massachusetts decided to cut its equity allocation last September, and so has so missed the entire +25% move in the S&P 500 since the end of September 2011.

This isn't just semantics, in my opinion.  This is real money.  By allocating assets away from the one class that could possibly deliver the returns necessary to achieve returns at least equal to 8%, PRIT has increased the state's pension liability, which will eventually have to met by the state's taxpayers.

Why didn't PRIT take the money from fixed income?  Why did they continue to allocate to hedge funds at a time when there is increasing evidence to suggest that hedge funds have largely failed to deliver the goods?  Why continue to hold more than 12% in illiquid real assets as an inflation hedge when deflation continues to loom as the greater threat?

Just asking.

Thursday, March 15, 2012

The True Cost of Avoiding Risk

We need higher returns!
The California Public Employees Retirement System (CalPERS) is one the largest investment portfolios in the world.

Totaling more than $220 billion, the investment strategies of CalPERS are widely followed among institutional investors.

So when CalPERS announced yesterday that it might be reducing its anticipated rate of return on its investment portfolio from 7.75% to 7.50%, it received considerable attention.

Moving from 7.75% to 7.50% may not seem like a big deal, except when you stop to consider that you're talking about billions of dollars.

Moreover, reducing the assumed rate of return on the CalPERS pension plan probably means that the contributions from the participants will need to be increased - just at a time when most municipal entities in California are already in precarious shape.

Here's how the Wall Street Journal described it yesterday:

A panel at Calpers voted Tuesday to lower a crucial investment target at the nation's largest pension fund, a step that could lead to higher retirement-plan costs or more job cuts in cities and counties across California. 

Calpers's pension and health-benefits committee recommended an assumed annual rate of return of 7.5%, down from the current 7.75%. If the pension system's board approves the change in a meeting Wednesday, it would mark the first time Calpers has lowered its overall investment assumption in nine years.

It would seem to me that this change is long overdue.

According CNBC, the average annual return for the CalPERS portfolio has averaged around 4.5% for the 10 years ending 12/31/10.

I have not been able to track down 2011 results, but even if they were good (and CalPERS CIO Joe Dear was quoted as saying they were "fabulous") it still means that the overall return for the fund for the past decade was well below its assumed rate.

With this in mind, then, it would seem logical that CalPERS should be allocating more assets to investment choices that offer at least the potential of boosting returns (i.e. stocks) while reducing their holdings of investments offering virtually no chance of getting anywhere close to 7.50% returns (i.e. bonds).

But that's not they're doing.

Here's a report from CNBC last September, right before the market started to rally:

The California Public Employees Retirement System is as worried as any investor about the uncertainty in the U.S. and Europe.

That's why Calpers, as it is known, is a "longterm trader" that is playing down equities, Chief Investment Officer Joe Dear told CNBC Wednesday. He indicated the Calpers portfolio is "underweight" equities by about 4 percent from its typical allocation

When you go to the CalPERS website, you see that just 48% of their portfolio is invested in public equities.

Meanwhile, 22% of the fund is invested in either "income" or "liquidity", both of which are essentially yielding less than 2%.

You would think that CalPERS would have investments with a very long term time horizon.  Most of the beneficiaries of the plan will be drawing their benefits for many years, but the yearly outflows are only a small fraction of the overall fund size.

But instead the group is investing with their eyes fixed firmly in the rear view mirror.  They have investments that will guard against inflation - with virtually no signs of inflation on the horizon.  They have huge investments in real estate and private equity, whose eventual returns are totally unknown.  They have hedge funds which, as a group, are probably barely earning their fees.

But common stocks - boring, large cap stocks trading at the most attractive level of valuation to bonds in more than 40 years - are getting a cold shoulder from the group, since they have been disappointing performers in the past decade.

This decision is not only likely to hurt returns, but also will cost the taxpayers of California. At a time when public services are being cut in many towns around the state, California municipalities are being forced to pony up more funds to keep the public pension plans funded.

Lessons to be learned for all investors.