Time to prune? | Seeking Alpha

Season and Direction

Many business people and some investors normally consider changing plans in September, focusing on the ends of December and January. Many will include the results of the mid-term elections in their timing decision.

Some merchants will focus on the end of January, which ends the retail trade year. With possible inventories out of balance and some uncertainty over shipments, particularly from Asia, there is a premium on having the correct inventories to sell quickly, utilizing a diminished senior sales staff.

Like Charlie Munger and Warren Buffett, my preferred holding period is forever. In my humble experience, there are times when it is wise to consider pruning the portfolio. Since the earliest investors were farmers, periodic pruning was normal. Even the best portfolio managers follow professional gardeners and prune their portfolios. A good portfolio is more than an accidental collection of securities. A sound portfolio should work well in most non-extreme markets.

As a contrarian, I do not accept we have entered a new “bull market”. I believe a new market cycle begins from a prior market’s beginning point. In this case, from its prior peak. What we are currently experiencing is a normal rally in a “bear market”. The main reason for this belief is that we have not even begun to address many of the causes of the last bull market’s problems, other than simply prices.

I regularly admit that I can be wrong. I urge investors to keep their pruning instruments handy on the chance that I am correct and equity markets decline. Pruning is a necessary tool for the survival of successful portfolio managers.

The Need to Prune

The reason one prunes is that it is an essential first step in repositioning the portfolio. The timing of the decision is not necessarily dependent on knowing what to add to the portfolio immediately.

There are two motivations to prune. The first is to reduce the level of panic when the market is in free fall. The second, which may not come from the first, is to build a buying reserve. Opportunities are easier to judge when one does not have to decide what to sell before you buy.

Voluntary and Involuntary Pruning

Since we have established the necessity to prune, the first way to do it is by the calendar, and the second is by the performance of the market.

I have already suggested a calendar prompt, which may be particularly apt in this troubled year. Using September as a month to make financial decisions may make unusual sense. It is the end of the US federal fiscal year and the beginning of the fall shopping season.

Some pundits are saying we have entered a new “bull market”. However, history suggests that a new bull market is usually led by new groups of stocks. The current leaders appear to once again be large-cap technology growth stocks. Going back to the old leaders suggests many of the pundits are failing to look for new leaders, ignoring many fund managers signaling caution.

One quick filter that could suggest candidates for pruning is measuring the growth of operating earnings between pre-COVID 2019 and 2021. If these operating earning did not rise 10% or more, an analyst should question a replay of old leadership being conducive to doing well.

There are other filters, such as evaluating whether the management of competitors has deteriorated or improved, and/or whether price and volume has materially changed. The key is to find some reason to do what racetrack handicappers do, which is to throw out a particularly bad race in assessing the future.

I have been a beneficiary of the involuntary pruning of positions held for some time, which made me question why they were continued to be attractive. (Please do not treat these examples as recommendations, which should only be made based on client needs and temperament.) The following discussion of five occurrences result from my background in the financial services industry, although the lessons can be profitably used in other sectors too.

ADP > CDK Global

I recognize my investing should be broader than the more familiar targets of mutual fund management companies and broker/dealers. Automatic Data Processing’s (ADP) historical basic business was relieving companies of their payroll processing and payment responsibility. They replaced commercial banks who initially dominated the field. ADP had superior data skills and a lower cost structure. They also learned the wonders of “free float” from Warren Buffett. Earning short-term interest on the payroll account. Since I was convinced the number of payrolls in the US were in a secular growth pattern, this stock was a good “common denominator” base position for a financial services fund.

As is often the case when one buys a good company, there may be a “kicker” in the purchase. ADP purchased or originated other financial services activities. But as good as many of these were, they were not as productive as ADP itself. Their usual approach was to spin off these companies to their shareholders, and a number of good ones went public.

One of these spin-offs was CDK Global, which provides data services to automobile dealers, automating their sales and service appointments. The number of individual auto dealers has been dropping and the number of larger multiple brand dealers has been growing. (Berkshire (BRK.A, BRK.B), Alleghany (Y), and the Washington Post, among others, are aggregators.) As CDK’s European business was in the process of being sold, its US activities sold separately at a good price. Thus, we involuntarily had a cash infusion during the “bear market”.

I kept ADP, which used its strong connections providing payroll services to assist clients in their hiring of financial services and other specialist. By the time this pattern became visible, they were already developing the business of “renting” employees to their clients and others. Initially, it was in the financial services business but expanded to other fields as well. (This “PEO” business made continued ownership of ADP even more attractive.)

Little “Berkshire” Joins the Big One

Alleghany Corp. was the old Kirby family holding company with a long history of owning interesting companies, including IDS, the forerunner of today’s Ameriprise. Alleghany is largely an interesting collection of casualty insurance companies, plus a collection of minority interests in a wide portfolio of ventures. Alleghany’s capable CEO recently retired and was replaced by a former CEO of General Reinsurance, which was acquired by Berkshire Hathaway. Alleghany is very familiar to Berkshire, so it was an easy decision for Mr. Buffett to make a cash acquisition offer for Allegheny to close later this year, at a record price. (No competing bid came in!)

Aetna > CVS Health and Eaton Vance

Two other holdings got new owners through a stock deal because they recognized a major change in the natures of their businesses.

As a newly married young US Marine Corps officer, I purchased a life insurance policy. When I entered the financial services field, I realized I had bought the wrong product from Aetna if I didn’t die early. Years later, it became clear to me that the cost of selling insurance was too expensive. Aetna’s management saw the same thing. They realized the healthcare industry had much better prospects, as did their competitor Cigna (CI). Aetna bought the larger CVS drug store chain. By combining its healthcare funding and processing capabilities with the storefronts. It then put medical professionals in the stores, and they were better addressing the needs of the public than by serving each of them separately. (In previous blogs, I mentioned three major sectors growing less efficient and not doing a good job: schooling, defense, and healthcare. CVS Health (CVS) is addressing some of the issues involved with the latter, which is one of the many causes of inflation and lack of growth.)

Eaton Vance is one of the oldest US mutual fund management companies. They have been one of the more innovative management companies developing new vehicles for institutional and individual investors. But the game has changed. Their original base was being one of two Boston-based investment advisors dealing with rich clients and offering funds for the related but less wealthy retail accounts. They sold their mutual funds and closed-end funds through commissions salespeople at major brokerage houses. The business changed with individual brokers restyling themselves as wealth managers, earning annual fees rather than commissions. These wealth managers have inserted themselves between the fund complex and the ultimate client. This has had two effects. The wealth manager feels compelled to prove his/her worth by having an opinion separate from that expressed by the asset manager at the fund company. All money management accounts lose money for the provider of investment services on day one of the relationships with the client. The client moves into a profit position with the asset manager over time. There is less effort in managing the account than getting it. In practice, the money stays with the wealth manager for less time, so the economic value of the relationship declines. In addition, Eaton Vance’s competitive strength is in sophisticated fixed-income and tax-managed products. With interest rates going lower, their book of business was becoming less profitable. A merger into Morgan Stanley (MS) locked in their largest wirehouse distributor and opened international distribution opportunities.

Thus, each of these involuntary prunings helped the owners of the accounts I manage.

Weekly Insights

1. The US Treasury inverted yield curves persist, with the 2-year yield higher (3.257%) than the 10-year (2.848%) and 30-year (3.117%). The bond market still sees a recession.
2. In a volatile week, the best-performing mutual fund investment objective was Natural Resources +8.24%, with General US Treasury -2.36% being the worst for the week ended Thursday.
3. The weekend edition of The Wall Street Journal tracks the prices of 72 stock indices, and index funds, commodities, and currencies. 93% were higher, catching Friday’s exuberance. The two that generated losses of 1% or more were the WSJ Dollar Index -1.05% and the Russian ruble -2.77%. Both could be of significance.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.