A recent episode of Freakonomics discussed a paper by Bronnenberg, Dube, Gentzkow and Shapiro that showed that informed consumers of headache remedies (such as pharmacists) were less likely to pay extra for national brands, preferring store brands and generics. BDGS suggest therefore that "misinformation explains a sizeable share of the brand premium for health products." In other words, those who are better informed can see past the veneer of marketing, and more accurately assess the quality of a product. Towards the end of the show, host Stephen Dubner asked the researchers (just G&S) if they thought similar results would hold true for other products - for example, if they thought that a university professor would use her educational expertise to send her child to a fairly priced second-tier university instead of an overpriced Ivy League school. G&S responded that they suspected that it would be quite the opposite - the university professor would be even more keen on sending her daughter to a top-rated university, regardless of price.
There's no doubt that we can learn a lot from how people act, rather than what they recommend. Gerd Gigerenzer says in "Risk Savvy" that one should never ask a doctor what he would recommend. Instead, one should ask the doctor, "What would you do for your mother?" Because I'm so very predictable, you might already have sniffed out where I'm heading with this. Naturally, I was listening to the podcast and wondering if the same result held true for investment professionals. I was intrigued by the analogy Dubner brought up at the end. Thinking about it a little more closely, I see a slight difference in the scenarios. Pharmacists are informed consumers and distributors, yet are not themselves producers of the remedies, and can therefore speak objectively. University professors and (some) investment professionals are more like producers. They are therefore either believers in the product they dispense, or have a cynical incentive to defend their product (reminiscent perhaps of Upton Sinclair's comment that it is difficult to get a man to understand something when his salary depends on his not understanding it).
Still, the question should be asked: are those involved in the active management of investments more or less likely to themselves invest in active strategies? I don't have the data, and a quick Internet search didn't turn up anything fruitful. You often hear hedge fund managers, for example, boast of "eating their own cooking", i.e. investing in their own funds, so I assume that this is common practice for many. But you hear some disquieting things as well. Blackstone's President Tony James recently commented on the hedge fund industry at an event, saying "A lot of people think about hedge funds as a way to get higher returns. Hedge funds are a way to play the stock market with somewhat lower volatility and somewhat lower returns. You don't expect hedge funds to get shoot-the-lights out returns. You save that for private equity and real estate." I found those to be extremely damning remarks from someone whose firm runs Blackstone Alternative Asset Management, which claims to be "the world's largest discretionary allocator to hedge funds, with $61 billion in assets under management." If I were paying a 10-20% performance fee, I would certainly be demanding something more than "somewhat lower volatility and somewhat lower returns" than the stock market. This would be doubly true if I were paying a second layer of fees to an allocator. To most of these intermediaries, I have no more to say than "See ya later, allocator."
The question of hedge fund returns is particular interesting right now. The debate over their value is reaching a crescendo with the news that California's pension fund, CalPERS, is exiting its hedge fund investments due to insufficient returns (post-expenses) and excessive complexity. Responses range from "If CalPERS thinks hedge funds are too complex, then who should invest in them?" to those saying "CalPERS simply didn't do a good enough job in its hedge fund portfolio."
Despite engaging in active asset allocation and security selection, I must confess my low regard for most active management. There are some truly spectacular investors out there who combine keen analysis with strong risk management and a contrarian bent. These people are few and far between, and chances are that if you've heard of them, it's too late. The average investor, I'm sorry to say, is best served by focusing on passive funds. Very often, active strategies are more headache than they're worth - so perhaps headache remedies and investment funds are not so different after all.
Thursday, September 25, 2014
Sunday, August 24, 2014
What Kind Of Dollar Do They Want?
Benjamin Cole ends his most recent blog post saying "To get to higher interest rates and inflation, we may have to endure years and years of prosperity. And even that may not work. I think we should try anyway." This is a terrific bit of writing, and will inflame those whom he calls the "righty-tighties".
I did, however, take slight issue with his first two comments, namely (a) that tight money is sacred to the right, and (b) that the right always finds monetary policy too loose. That is (deliberately, I'm sure) exaggerated, and thus unfair to the right. The likes of David Beckworth and Ramesh Ponnuru have published numerous times in the National Review in favour of easier monetary policy, as has Jim Pethokoukis at the AEI. Still, Benjamin's jibe raises a valid question: What kind of dollar does that faction of the right want?
"Sound money" is often advocated by Internet Austrians, but is a sufficiently imprecise concept as to be unhelpful. In theory, there should be plenty of middle ground between those who desire "sound money" and flexible inflation targeters. However, some common objections to FIT are (1) the Fed's dual mandate is wrong, and should focus solely on inflation; (2) "sound money" demands no inflation (and hence no loss of purchasing power), not the unforgivable 2% inflation that most central banks target, (3) the Fed uses incorrect (and possibly doctored) inflation statistics to hide its inflationary bias, revealed by ShadowStats and other sources, and (4) the only way to ensure sound money is to rid the world of fiat currency.
While I won't go through the counter-arguments to these (incorrect, in my opinion) points, it's worth noting that this is an age-old debate. This 1896 paper from Fred M. Taylor, for example, evaluates the merits of an "elastic currency" - language that made it into the Federal Reserve Act of 1913 - defined loosely as "a currency the amount of which varies in accord with the needs of industry." While the terminology is archaic, it is the precursor to the Fed's dual mandate. Taylor seems to conflate the concepts of money and credit in the paper, but he properly distinguishes between ordinary and emergency elasticity, writing "By the former, I mean that elasticity which adapts the amount of the currency to the varying needs of trade within the limits of a single ordinary year. By "emergency elasticity", on the other hand, I mean the capacity of the currency to adjust itself to those fluctuations in the need for money which characterize a panic." The concept of "emergency elasticity" is one that "sound money" types seem to ignore. Taylor notes that at the time of writing, victory belonged to "the advocates of a safe rather an an elastic currency." While the supporters of elasticity are mainstream today, "sound money" proponents seem to yearn for a return to "safety". The costs of this safety, however, surely deserve attention.
Equally worth of criticism is the "Strong Dollar" demanded by other righty-tighties. Many "Strong Dollar" types seem to be business people who pride themselves on their practical leanings and material success, and decry the Fed's intervention in the free clearing of a market (unless dollar strength limits their ability to export - there sometimes seem to be fewer true libertarians in business than there are atheists in foxholes!). Alas, these practical types do not seem to realize that they would scoff heartily at fellow producers who decided that their sole goal in business should be a "strong price". Yes, business people seek the strongest price possible, but within the limits of competition. What they truly aim for is the strongest price that customers will bear, and which results in the highest total profit (broadly speaking). To seek a strong price ignoring customers' willingness to pay would be madness. Furthermore, when demand is high for their goods, these producers often increase supply, but criticise the Fed for pursuing a similar course of action (as the Fed should rightly do, when furnishing emergency elasticity, for exampe).
No doubt we'll be hearing more from the righty-tighties as the pressure mounts on the FOMC to raise rates. It's even possible that at some point they'll be right. But the rest of us should remind them they've been consistently wrong for the past 7 years. While "sound money" and "strong dollar" policies sound inoffensive at first blush, the faulty thinking underlying them cannot be allowed to infect central banks, who may face pressure from politicians looking to score points. We've seen how that's played out in Europe, and to allow such thinking to fester anywhere else is an invitation for trouble.
I did, however, take slight issue with his first two comments, namely (a) that tight money is sacred to the right, and (b) that the right always finds monetary policy too loose. That is (deliberately, I'm sure) exaggerated, and thus unfair to the right. The likes of David Beckworth and Ramesh Ponnuru have published numerous times in the National Review in favour of easier monetary policy, as has Jim Pethokoukis at the AEI. Still, Benjamin's jibe raises a valid question: What kind of dollar does that faction of the right want?
"Sound money" is often advocated by Internet Austrians, but is a sufficiently imprecise concept as to be unhelpful. In theory, there should be plenty of middle ground between those who desire "sound money" and flexible inflation targeters. However, some common objections to FIT are (1) the Fed's dual mandate is wrong, and should focus solely on inflation; (2) "sound money" demands no inflation (and hence no loss of purchasing power), not the unforgivable 2% inflation that most central banks target, (3) the Fed uses incorrect (and possibly doctored) inflation statistics to hide its inflationary bias, revealed by ShadowStats and other sources, and (4) the only way to ensure sound money is to rid the world of fiat currency.
While I won't go through the counter-arguments to these (incorrect, in my opinion) points, it's worth noting that this is an age-old debate. This 1896 paper from Fred M. Taylor, for example, evaluates the merits of an "elastic currency" - language that made it into the Federal Reserve Act of 1913 - defined loosely as "a currency the amount of which varies in accord with the needs of industry." While the terminology is archaic, it is the precursor to the Fed's dual mandate. Taylor seems to conflate the concepts of money and credit in the paper, but he properly distinguishes between ordinary and emergency elasticity, writing "By the former, I mean that elasticity which adapts the amount of the currency to the varying needs of trade within the limits of a single ordinary year. By "emergency elasticity", on the other hand, I mean the capacity of the currency to adjust itself to those fluctuations in the need for money which characterize a panic." The concept of "emergency elasticity" is one that "sound money" types seem to ignore. Taylor notes that at the time of writing, victory belonged to "the advocates of a safe rather an an elastic currency." While the supporters of elasticity are mainstream today, "sound money" proponents seem to yearn for a return to "safety". The costs of this safety, however, surely deserve attention.
Equally worth of criticism is the "Strong Dollar" demanded by other righty-tighties. Many "Strong Dollar" types seem to be business people who pride themselves on their practical leanings and material success, and decry the Fed's intervention in the free clearing of a market (unless dollar strength limits their ability to export - there sometimes seem to be fewer true libertarians in business than there are atheists in foxholes!). Alas, these practical types do not seem to realize that they would scoff heartily at fellow producers who decided that their sole goal in business should be a "strong price". Yes, business people seek the strongest price possible, but within the limits of competition. What they truly aim for is the strongest price that customers will bear, and which results in the highest total profit (broadly speaking). To seek a strong price ignoring customers' willingness to pay would be madness. Furthermore, when demand is high for their goods, these producers often increase supply, but criticise the Fed for pursuing a similar course of action (as the Fed should rightly do, when furnishing emergency elasticity, for exampe).
No doubt we'll be hearing more from the righty-tighties as the pressure mounts on the FOMC to raise rates. It's even possible that at some point they'll be right. But the rest of us should remind them they've been consistently wrong for the past 7 years. While "sound money" and "strong dollar" policies sound inoffensive at first blush, the faulty thinking underlying them cannot be allowed to infect central banks, who may face pressure from politicians looking to score points. We've seen how that's played out in Europe, and to allow such thinking to fester anywhere else is an invitation for trouble.
Sunday, August 17, 2014
Ebola, and Reflecting On 2007-2008
Twitter's excellent Sober Look pointed me towards the WHO's disconcerting warning that the current Ebola outbreak has been underestimated. The WHO believes that the number of reported cases and deaths is being underestimated, as is the time expected to fully contain the outbreak. This caught my eye because I had earlier insisted on Twitter that news consumers were overplaying the risks of Ebola, while ignoring the potential significance of China's hukou reforms in improving the social and economic lives of millions of people. I don't know if the Ebola outbreak is cause for concern for those outside of West Africa, especially as other commentators like Dan Drezner decry Ebola scaremongering, but I was reminded of another time when I was wrong in assessing the risk of a situation, i.e. evaluating the economy and financial markets in 2007-08.
Seven years after the onset of the Great Recession, there are many competing theories about what happened to produce such a financial and economic catastrophe. I wrote a post praising Ed Catmull's "Creativity, Inc." last week, and this quote stood out to me, among other gems: "Hindsight is not 20/20. Not even close. Our view of the past, in fact, is hardly clearer than our view of the future. While we know more about a past event than a future one, our understanding of the factors that shaped it is severely limited. Not only that, because we think we what happened clearly - hindsight being 20/20 and all - we often aren't open to knowing more." I won't even attempt to rehash the arguments, but will merely state my view that financial fragility caused by high leverage, poorly understood products and contagion effects interacted with some pernicious monetary policy decisions to create the crisis. Despite my deep interest in prior financial panics, I believed that the subprime debacle in the US would be contained, leading to a recession but not the mini-Depression that ensued. Suffice to say I was wrong. I had an insufficient appreciation for the hidden leverage throughout the financial system and the potential for contagion. I also failed to foresee that major central banks were allowing monetary conditions to tighten like a vise around their economies.
I'll let myself off the hook slightly by conceding that it is the very nature of complex adaptive systems that leads to such surprising outcomes. Furthermore, I'm certainly not saying that this Ebola outbreak is the health equivalent of 2007-2008. I'm merely recognizing that there is more to be worried about when contagion is involved. This is in contrast with that other recent favourite of scaremongering journalists, the spate of air crashes worldwide. While I view the air crashes as largely independent and random events, the contagion characteristics of an epidemic offer greater cause for concern.
So what would have been the appropriate response in 2007-2008? This is a more difficult question than it seems. As Kissinger says in his book "On China", "Analysis depends on interpretation; judgments differ as to what constitutes a fact, even more about its significance." An omniscient trading genius would have been heavily short by May 2008, and would have reversed course in Mar 2009. This is highly unrealistic, and much easier said than done, since anyone smart (or nervous) enough to have sold in May 2008 would likely have had an aversion to re-entering the market even when it was cheap (relative to fundamentals) in middle to late 2009. The hardy few will suggest that the best path would have been to do absolutely nothing. After all, if Lehman's bankruptcy had put you in Rip Van Winkle state on 16 Sep 2008, you could have woken up on Apr 23, 2010 to find the S&P 500 unchanged at 1213. Of course, this ignores the opportunity cost of maintaining your holdings - you could have sold on 16 Sep and had the opportunity to buy at lower levels.
Thankfully we have two tools that can aid us in this difficult task, namely (a) valuation and (b) scenario analysis. Valuation provides an anchor while the investor is buffeted by waves of events and information. Scenario analysis allows us to consider various possibilities and incorporate them into our valuation. Both have to be subject to rigorous scrutiny, because "valuation" can ossify into dogma, ignoring changing facts and the multitude of assumptions under the surface of purported precision. I suspect using these two tools in 2007-2008 would have led an investor to be less long (it takes a different mindset to short successfully), and would have allowed the investor to gradually increase his exposure throughout 2009 (and indeed, through 2013, when I think stocks went from being cheap to being fairly priced).
These are not easy judgments to make, and this, after all, is why truly talented investors deserve to be compensated accordingly. Combining the relevant financial analysis with a subtle appreciation of the sociology of markets requires an unusual calibre of investor. If you find that person, I suggest you hold on to her - and suggest equally that you prevent her from undertaking any non-essential travel to the affected West African countries until we better understand the extent of this outbreak.
Sunday, August 10, 2014
Creativity, Inc., and The Last Liberal Art
I rarely delve into the genre best described as "General Management" since I quickly get annoyed with formulaic nostrums for success and the lionization of specific business leaders, particularly where they appear to have been lucky rather than good. But I'd heard so much positive press about Ed Catmull's "Creativity, Inc." that I decided to dip my toe in just this once. I'm grateful that I did, because Catmull's book is extremely atypical of the genre. Catmull is one of the co-founders of Pixar, and the current President of Pixar, Disney Animation and DisneyToon. He offers a fascinating look at Pixar's history, including its many challenges throughout its history. Steve Jobs fans will find the book worthwhile simply for the anecdotes about him, and an afterword describing his contribution to Pixar. But even more importantly, I think the book has lessons for those outside what we traditionally see as "creative" industries. It won't surprise friends and long-time readers that I think of investing as a creative enterprise to a large degree (note that I said "investing" rather than "finance", since I don't think loan officers, for example, should be too creative in their professional lives - we know how that ends!). That said, I do think that even those who are unambiguously outside the "creative" world (e.g. commercial bankers) can learn a lot about creating strong and flexible organizations from Catmull's deep insights into these issues (as I summarize in the third paragraph).
I imagine there are many people who will take issue with my suggestion that investing should be creative. For some, "creative" investing has the whiff of Madoff-style deception, or Victor Niederhoffer-style volatility. For others, investing is best pursued by mechanical rules, either through index funds, dollar-cost averaging or algorithms tied to valuations. It is difficult to refute each of these individually, and I have a fair amount of sympathy for those who eschew active management at all costs. And it seems that active managers have understood their customers well, realizing that career longevity is tied to avoiding underperformance, rather than maximizing long-term performance, as Porter and Trifts have shown. Nonetheless, I maintain that that rare breed of manager - the alpha generator - must be creative in generating ideas, skilled in adapting to the complex currents of economies and markets, and humble in the face of mistakes. Robert Hagstrom was spot-on when he brilliantly described investing as the "last liberal art", and Catmull echoes this in his book when he writes, "Craft is what we are expected to know; art is the unexpected use of our craft."
Catmull's book touches on many themes close to my heart - uncertainty, randomness, and social dynamics, among others. It is difficult to capture his lessons adequately without the resonance of his anecdotes about Pixar. Nevertheless, here are some of the broader lessons that are applicable to creating strong, loosely "creative" organizations:
- Make a policy of hiring people smarter than you are, no matter how threatening it may seem as a manager. An organization that is committed to seniority is doomed to mediocrity.
- "If you give a good idea to a mediocre team, they'll screw it up. If you give a mediocre idea to a brilliant team, they will either fix it or throw it away and come up with something better. Getting the right people and the right chemistry is more important than getting the right idea."
- Create organizations where people are encouraged to - and see it as their duty to - communicate problems and offer solutions. Many problems lie hidden from the view of management.
- Candid and bracing (but constructive) feedback and the iterative process allows creativity to be channelled into an end product. "You are not your ideas, and if you identify too closely with your ideas, you will take offense when they are challenged."
- "Mistakes aren't a necessary evil. They aren't evil at all. They are an inevitable consequence of doing something new (and, as such, should be seen as valuable; without them we'd have no originality)."
- Leaders should talk about their mistakes to make it safe for others to follow suit.
- "While we don't want too many failures, we must think of the cost of failure as an investment in the future."
- "The antidote to fear is trust...Trusting others doesn't mean that they won't make mistakes. It means that if they do (or if you do), you trust that they will act to help solve it."
- "Management's job is not to prevent risk but to build the ability to recover."
- "When someone hatches an original idea, it may be ungainly and poorly defined, but it is also the opposite of established and entrenched - and that is precisely what is most exciting about it."
- "In an unhealthy culture, each group believes that if their objectives trump the goals of the other groups, the company will be better off. In a healthy culture, all constituencies recognize the importance of balancing competing desires - they want to be heard, but they don't have to win."
- "Randomness is not just inevitable; it is part of the beauty of life. Acknowledging it and appreciating it helps us respond constructively when we are surprised."
- "Those with superior talent and the ability to marshal the energies of others have learned from experience that there is a sweet spot between the known and the unknown where originality happens; the key is to be able to linger without panicking."
- Hindsight is not 20-20. "While we know more about a past event than a future one, our understanding of the factors that shaped it is severely limited", so we must be cautious about drawing generalized lessons from events.
- Creativity is "unexpected connections between unrelated concepts or ideas", and we need to be in a certain mindset to make those connections.
- "Our specialized skills and mental models are challenged when we integrate with people who are different."
- "Measure what you can, evaluate what you can measure, and appreciate that you cannot measure the vast majority of what you do."
As I re-read this, I realize there is the danger of this coming across as a bunch of management-speak platitudes, but I urge you again to read the book for yourself and mull over a book that I hope to return to many times in the future.
I imagine there are many people who will take issue with my suggestion that investing should be creative. For some, "creative" investing has the whiff of Madoff-style deception, or Victor Niederhoffer-style volatility. For others, investing is best pursued by mechanical rules, either through index funds, dollar-cost averaging or algorithms tied to valuations. It is difficult to refute each of these individually, and I have a fair amount of sympathy for those who eschew active management at all costs. And it seems that active managers have understood their customers well, realizing that career longevity is tied to avoiding underperformance, rather than maximizing long-term performance, as Porter and Trifts have shown. Nonetheless, I maintain that that rare breed of manager - the alpha generator - must be creative in generating ideas, skilled in adapting to the complex currents of economies and markets, and humble in the face of mistakes. Robert Hagstrom was spot-on when he brilliantly described investing as the "last liberal art", and Catmull echoes this in his book when he writes, "Craft is what we are expected to know; art is the unexpected use of our craft."
Catmull's book touches on many themes close to my heart - uncertainty, randomness, and social dynamics, among others. It is difficult to capture his lessons adequately without the resonance of his anecdotes about Pixar. Nevertheless, here are some of the broader lessons that are applicable to creating strong, loosely "creative" organizations:
- Make a policy of hiring people smarter than you are, no matter how threatening it may seem as a manager. An organization that is committed to seniority is doomed to mediocrity.
- "If you give a good idea to a mediocre team, they'll screw it up. If you give a mediocre idea to a brilliant team, they will either fix it or throw it away and come up with something better. Getting the right people and the right chemistry is more important than getting the right idea."
- Create organizations where people are encouraged to - and see it as their duty to - communicate problems and offer solutions. Many problems lie hidden from the view of management.
- Candid and bracing (but constructive) feedback and the iterative process allows creativity to be channelled into an end product. "You are not your ideas, and if you identify too closely with your ideas, you will take offense when they are challenged."
- "Mistakes aren't a necessary evil. They aren't evil at all. They are an inevitable consequence of doing something new (and, as such, should be seen as valuable; without them we'd have no originality)."
- Leaders should talk about their mistakes to make it safe for others to follow suit.
- "While we don't want too many failures, we must think of the cost of failure as an investment in the future."
- "The antidote to fear is trust...Trusting others doesn't mean that they won't make mistakes. It means that if they do (or if you do), you trust that they will act to help solve it."
- "Management's job is not to prevent risk but to build the ability to recover."
- "When someone hatches an original idea, it may be ungainly and poorly defined, but it is also the opposite of established and entrenched - and that is precisely what is most exciting about it."
- "In an unhealthy culture, each group believes that if their objectives trump the goals of the other groups, the company will be better off. In a healthy culture, all constituencies recognize the importance of balancing competing desires - they want to be heard, but they don't have to win."
- "Randomness is not just inevitable; it is part of the beauty of life. Acknowledging it and appreciating it helps us respond constructively when we are surprised."
- "Those with superior talent and the ability to marshal the energies of others have learned from experience that there is a sweet spot between the known and the unknown where originality happens; the key is to be able to linger without panicking."
- Hindsight is not 20-20. "While we know more about a past event than a future one, our understanding of the factors that shaped it is severely limited", so we must be cautious about drawing generalized lessons from events.
- Creativity is "unexpected connections between unrelated concepts or ideas", and we need to be in a certain mindset to make those connections.
- "Our specialized skills and mental models are challenged when we integrate with people who are different."
- "Measure what you can, evaluate what you can measure, and appreciate that you cannot measure the vast majority of what you do."
As I re-read this, I realize there is the danger of this coming across as a bunch of management-speak platitudes, but I urge you again to read the book for yourself and mull over a book that I hope to return to many times in the future.
Sunday, July 27, 2014
Lessons from the Masters of PE and VC for Mere Mortals
I've just finished Robert Finkel's "The Masters of Private Equity and Venture Capital", and thought it merited some quick thoughts. First off, it's an easy read that I recommend, and a good introduction for those not immersed in the worlds of PE and VC. The roster of characters interviewed will probably interest even those who know PE and VC well, with stalwarts like Joe Rice, Warren Hellman, John Canning, William Draper and Franklin "Pitch" Johnson making appearances. Some of the anecdotes are amazing, such as Canning breezily relating how banks like First Chicago used their PE arms to smooth earnings. This practice became harder with the advent of mark-to-market, leading to the spin-off of future titans like Madison Dearborn. Some of the less-known stories are just as interesting. Steven Lazarus describes the creation of ARCH Venture Partners, designed to commercialize and monetize research from the University of Chicago. This seems a natural outgrowth of research, but it had never crossed my mind that such entities existed. While I was left a little disappointed with the chapter on Jeffrey Walker, his work bringing a PE approach to the Millennium Villages will interest those who have followed the debate over Jeffrey Sachs' ambitious project (particularly if you have heard these EconTalk podcasts with Nina Munk and Jeff Sachs.)
No book on PE or VC would be complete with a reference to Georges Doriot, widely considered the founding father of these two fields. In his introduction, Finkel quotes Doriot: "The study of a company is not the study of a dead body. It is not similar to an autopsy. It is the study of things and relationships. It is the study of something very much alive which falls or breaks up unless constantly pushed ahead or improved. It is the study of men and men's work, of their hopes and aspirations. The study of the tools and methods they selected and built. It is the study of conceptions and creations - imagination - hopes and disillusions."
I thought Doriot's quote was an important one. Finkel's book, presumably meant for a popular audience, steers clear of arcane descriptions of valuation and financing. Yet this also reflects that financial wizardry is not the only ingredient for success in these businesses, or any branch of investing, for that matter. The venerable Pitch Johnson recounts his transition from the steel industry to VC, and counsels, "A person picks up a lot of lessons over time, and the person who pays attention, even in places as seemingly dissimilar as steel mills and biotech labs, has a good chance of backing the right people, with the right ideas, in the right markets." Being an "intellectual magpie", as my former English teacher would describe it, is exceptionally beneficial in the business of investing. Finkel concurs, pointing out that "Many of the major sources of competitive advantage for the private-investment asset class are qualitative in nature: picking the right companies, mentoring their managements, measuring their performance, and driving them toward success... Moving from deal to a successful long-term investment requires patience, a human touch, strategic insight, and ultimately a keen assessment of a company's market value and potential."
Another crucial element the book describes in PE, in particular, is operational excellence (and I mean genuine insight, not just having someone who did an internship at consulting firm once). David Swensen, who allocates billions to PE as head of Yale's phenomenally successful endowment, has very cutting words for most PE fund managers, describing them essentially as investment bankers with mid-life crises. He derides most PE funds as providing commoditized financing, and insists on only investing in those that can provide operational guidance to portfolio companies. Speaking about Russian PE, Patricia Cloherty reflects,"Private property is a new concept, so negotiations focus exhaustively on price with a wholly inadequate emphasis on the strategic development of the company." It seems to me that western PE firms who lack operational expertise will similarly be relegated to bidding for companies with insufficient interest from firms who can offer both operational and financial expertise. The results for LPs are unlikely to be satisfactory.
Much like the hedge fund industry, PE and VC seem to have become more professionalized, and perhaps less lucrative for LPs. As Pitch Johnson observes, "After the dot-come crash of 2000, when the venture market came back, it came back in a different form than previously. It became a big money management business." Carl Thoma explains just how difficult the game has become: "Information flows a lot faster than it once did, and there are about five times as many firms out there competing for deals compared to when we started out." He goes on to say, "It's just a different game, and the old investment process no longer works as effectively."
Given the exceptional suite of skills needed to be a top-tier PE or VC manager, and the increasingly competitive arena, it is therefore doubtful that most limited partners are getting what they pay for. Investment talent is scarce, and requires organizational frameworks that can nurture it. I am fairly skeptical that most "alternative assets" will prove worthwhile for limited partners - but I'm sure that many mediocre intermediaries will do fine off of management and incentive fees.
I'll end with some customary speculation. There has been a lot of interesting discussion among monetary policy commentators about whether today's central bankers are exceptionally averse to inflation given their coming of age in the mid to late 70s. I was intrigued by Patricia Cloherty's horrified observation that "In the early 1990s many young business people in Russia told me that they learned much of what they knew about business by watching films such as Wall Street with Michael Douglas." It struck me that someone who had "come of age" in the world of finance in 1987, when Wall Street came out, would have been about 45 in 2007 as various unseemly business practices in the world of finance became visible. One can only hope that this cohort of fairly senior people was not overly influenced by Gordon Gekko. It's an unfortunate indictment of a certain type of character drawn to finance that both Oliver Stone and Michael Lewis intended Wall Street and Liar's Poker to be cautionary tales about the noxious greed in the industry, but were both ultimately dismayed that their stories were instead seen as exemplars for ambitious young people.
No book on PE or VC would be complete with a reference to Georges Doriot, widely considered the founding father of these two fields. In his introduction, Finkel quotes Doriot: "The study of a company is not the study of a dead body. It is not similar to an autopsy. It is the study of things and relationships. It is the study of something very much alive which falls or breaks up unless constantly pushed ahead or improved. It is the study of men and men's work, of their hopes and aspirations. The study of the tools and methods they selected and built. It is the study of conceptions and creations - imagination - hopes and disillusions."
I thought Doriot's quote was an important one. Finkel's book, presumably meant for a popular audience, steers clear of arcane descriptions of valuation and financing. Yet this also reflects that financial wizardry is not the only ingredient for success in these businesses, or any branch of investing, for that matter. The venerable Pitch Johnson recounts his transition from the steel industry to VC, and counsels, "A person picks up a lot of lessons over time, and the person who pays attention, even in places as seemingly dissimilar as steel mills and biotech labs, has a good chance of backing the right people, with the right ideas, in the right markets." Being an "intellectual magpie", as my former English teacher would describe it, is exceptionally beneficial in the business of investing. Finkel concurs, pointing out that "Many of the major sources of competitive advantage for the private-investment asset class are qualitative in nature: picking the right companies, mentoring their managements, measuring their performance, and driving them toward success... Moving from deal to a successful long-term investment requires patience, a human touch, strategic insight, and ultimately a keen assessment of a company's market value and potential."
Another crucial element the book describes in PE, in particular, is operational excellence (and I mean genuine insight, not just having someone who did an internship at consulting firm once). David Swensen, who allocates billions to PE as head of Yale's phenomenally successful endowment, has very cutting words for most PE fund managers, describing them essentially as investment bankers with mid-life crises. He derides most PE funds as providing commoditized financing, and insists on only investing in those that can provide operational guidance to portfolio companies. Speaking about Russian PE, Patricia Cloherty reflects,"Private property is a new concept, so negotiations focus exhaustively on price with a wholly inadequate emphasis on the strategic development of the company." It seems to me that western PE firms who lack operational expertise will similarly be relegated to bidding for companies with insufficient interest from firms who can offer both operational and financial expertise. The results for LPs are unlikely to be satisfactory.
Much like the hedge fund industry, PE and VC seem to have become more professionalized, and perhaps less lucrative for LPs. As Pitch Johnson observes, "After the dot-come crash of 2000, when the venture market came back, it came back in a different form than previously. It became a big money management business." Carl Thoma explains just how difficult the game has become: "Information flows a lot faster than it once did, and there are about five times as many firms out there competing for deals compared to when we started out." He goes on to say, "It's just a different game, and the old investment process no longer works as effectively."
Given the exceptional suite of skills needed to be a top-tier PE or VC manager, and the increasingly competitive arena, it is therefore doubtful that most limited partners are getting what they pay for. Investment talent is scarce, and requires organizational frameworks that can nurture it. I am fairly skeptical that most "alternative assets" will prove worthwhile for limited partners - but I'm sure that many mediocre intermediaries will do fine off of management and incentive fees.
I'll end with some customary speculation. There has been a lot of interesting discussion among monetary policy commentators about whether today's central bankers are exceptionally averse to inflation given their coming of age in the mid to late 70s. I was intrigued by Patricia Cloherty's horrified observation that "In the early 1990s many young business people in Russia told me that they learned much of what they knew about business by watching films such as Wall Street with Michael Douglas." It struck me that someone who had "come of age" in the world of finance in 1987, when Wall Street came out, would have been about 45 in 2007 as various unseemly business practices in the world of finance became visible. One can only hope that this cohort of fairly senior people was not overly influenced by Gordon Gekko. It's an unfortunate indictment of a certain type of character drawn to finance that both Oliver Stone and Michael Lewis intended Wall Street and Liar's Poker to be cautionary tales about the noxious greed in the industry, but were both ultimately dismayed that their stories were instead seen as exemplars for ambitious young people.
Wednesday, July 23, 2014
Scenario Analysis & The Depressing Fed
I was reading Brealey, Myers and Allen on scenario analysis today, and was struck with a depressing thought. Scenario analysis, to clarify, looks at a limited number of combination of variables, and examines the effects of these various combinations on the net present value of a project or on firm enterprise value. This is an essential tool for any analyst. Perhaps my favourite quote on de facto scenario analysis comes from Bruce Kovner, who said "One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what the world should be like and wait for one of them to be confirmed. You keep trying them on one at a time." Kovner believed this was one of his competitive advantages: "I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine that soybean prices can double or that the dollar can fall to 100 yen."
I no doubt lack Kovner's creativity in imagining different macro scenarios, but I'm finding it desperately difficult to imagine a booming US economy. It seems very unlikely that the Fed wants to recover the lost NGDP gap from the Great Recession, and David Beckworth has highlighted evidence suggesting the Fed is targeting a corridor of 1-2% PCE growth. Expectations for growth, and to corporate earnings generally, must therefore be muted.
I'm not bearish by temperament, despite some cautious (some might say pessimistic) posts of late. I'm not predicting an imminent market correction, or suggesting that stocks are overvalued. I am inclined, however, to believe that a reasonable scenario analysis would assign a higher probability to a bear case than to a bull case.
Ryan Avent has also written an excellent post discussing the two-way interaction between Fed policy and the labour market, while Ambrose Evans-Pritchard believes Janet Yellen is less dovish than consensus perception. I'm reminded of the work of the sociologist Katherine Newman, which you can read in her books, or listen to on this superb EconTalk episode. Newman's ethnographic work recounts how marginal workers were brought into employment by the booming economy of the mid to late 1990s. As Marcus Nunes notes, this was the byproduct of the (accidental?) delivery of stable NGDP growth. Today, with low labour participation rates and the masses of the long-term unemployed growing, the Fed's determination to stave off any nascent inflation and secure financial stability (two separate, and possibly contradictory goals within the current framework) seems unnecessarily cautious. Try as I may to channel Kovner, it's hard to see anything but a negative skew to my scenario analysis.
I no doubt lack Kovner's creativity in imagining different macro scenarios, but I'm finding it desperately difficult to imagine a booming US economy. It seems very unlikely that the Fed wants to recover the lost NGDP gap from the Great Recession, and David Beckworth has highlighted evidence suggesting the Fed is targeting a corridor of 1-2% PCE growth. Expectations for growth, and to corporate earnings generally, must therefore be muted.
I'm not bearish by temperament, despite some cautious (some might say pessimistic) posts of late. I'm not predicting an imminent market correction, or suggesting that stocks are overvalued. I am inclined, however, to believe that a reasonable scenario analysis would assign a higher probability to a bear case than to a bull case.
Ryan Avent has also written an excellent post discussing the two-way interaction between Fed policy and the labour market, while Ambrose Evans-Pritchard believes Janet Yellen is less dovish than consensus perception. I'm reminded of the work of the sociologist Katherine Newman, which you can read in her books, or listen to on this superb EconTalk episode. Newman's ethnographic work recounts how marginal workers were brought into employment by the booming economy of the mid to late 1990s. As Marcus Nunes notes, this was the byproduct of the (accidental?) delivery of stable NGDP growth. Today, with low labour participation rates and the masses of the long-term unemployed growing, the Fed's determination to stave off any nascent inflation and secure financial stability (two separate, and possibly contradictory goals within the current framework) seems unnecessarily cautious. Try as I may to channel Kovner, it's hard to see anything but a negative skew to my scenario analysis.
Friday, July 18, 2014
To Panic or Not To Panic?
I'll keep this post short as I shake off the rust on my blog after a 2-month hiatus. It seems to be a day for serious geopolitical news with word coming that pro-Russian forces have mistakenly shot down a Malaysia Airlines passenger plane at the same time that Israel has launched a ground offensive in Gaza. Tren Griffin has wisely counselled investors to focus on their process and stay rational by tuning out noise, echoing the excellent advice Meb Faber offered 8 days ago.
I can't agree enough with that statement. Equanimity and the ability to step back from one's emotions are crucial parts of investing that aren't sufficiently cultivated. Yet this doesn't mean ignoring geopolitical news. Investors need to find a way to incorporate geopolitical shocks into a methodical framework. Frankly, this is easier said than done. Financial markets are complex adaptive systems, and one of the characteristics of such systems is non-linearity, i.e. the propensity for small inputs, physical interactions or stimuli to cause large effects or significant changes in output.
Another reason we have to wrestle with geopolitical news is that these events can be genuine shocks within an AD/AS framework. For example, Lars Christensen noted the aggregate supply shock resulting from the Russian invasion of Crimea. Aggregate demand shocks, too, are rampant. I recently saw "Five Years From The Brink", a documentary focusing on Hank Paulson's role as Treasury Secretary during the panic of 2008 (I wouldn't rush out to get it, although it does offer the benefit of hindsight). One thing that struck me was his point that each of the beleaguered financial institutions would have constituted a full-blown crisis on its own, and that policy-makers from Treasury and the Fed (to name a few) had multiple balls of crisis up in the air at the same time. This, undoubtedly, prevented the Fed from acting sooner in its role as monetary policy-setter as it went instead into crisis mode. The revival of geopolitical tensions requires the attention of policy-makers who may therefore neglect the importance of monetary policy (weakening AD) or investments in education and infrastructure (weakening AS). None of these things is good.
The reality is, therefore, that investors need to incorporate geopolitics into their frameworks, either by setting out various scenarios and assigning probabilities to them, or by demanding a buffer of safety in their investments. My suspicion is that the current bad news is not sufficient to derail the global economic recovery. Those who are bearish today, however, may turn out to be right for the wrong reasons. Ambrose Evans-Pritchard warns of a possible dollar squeeze in the offing, as Lars Christensen is rightly concerned about the Fed's stock-picking. I had to wonder today on Twitter if biotech and social media stocks will prove to be the magnets making the Fed's monetary compass malfunction, as oil did in 2008. I certainly hope not, for if so, the modest expectations for growth that I and other investors hold may still prove to be too optimistic. So, to answer the eternal question - to panic or not to panic? - I offer the measured, "It depends on your framework." But I hope you have one, because it may soon be challenged.
I can't agree enough with that statement. Equanimity and the ability to step back from one's emotions are crucial parts of investing that aren't sufficiently cultivated. Yet this doesn't mean ignoring geopolitical news. Investors need to find a way to incorporate geopolitical shocks into a methodical framework. Frankly, this is easier said than done. Financial markets are complex adaptive systems, and one of the characteristics of such systems is non-linearity, i.e. the propensity for small inputs, physical interactions or stimuli to cause large effects or significant changes in output.
Another reason we have to wrestle with geopolitical news is that these events can be genuine shocks within an AD/AS framework. For example, Lars Christensen noted the aggregate supply shock resulting from the Russian invasion of Crimea. Aggregate demand shocks, too, are rampant. I recently saw "Five Years From The Brink", a documentary focusing on Hank Paulson's role as Treasury Secretary during the panic of 2008 (I wouldn't rush out to get it, although it does offer the benefit of hindsight). One thing that struck me was his point that each of the beleaguered financial institutions would have constituted a full-blown crisis on its own, and that policy-makers from Treasury and the Fed (to name a few) had multiple balls of crisis up in the air at the same time. This, undoubtedly, prevented the Fed from acting sooner in its role as monetary policy-setter as it went instead into crisis mode. The revival of geopolitical tensions requires the attention of policy-makers who may therefore neglect the importance of monetary policy (weakening AD) or investments in education and infrastructure (weakening AS). None of these things is good.
The reality is, therefore, that investors need to incorporate geopolitics into their frameworks, either by setting out various scenarios and assigning probabilities to them, or by demanding a buffer of safety in their investments. My suspicion is that the current bad news is not sufficient to derail the global economic recovery. Those who are bearish today, however, may turn out to be right for the wrong reasons. Ambrose Evans-Pritchard warns of a possible dollar squeeze in the offing, as Lars Christensen is rightly concerned about the Fed's stock-picking. I had to wonder today on Twitter if biotech and social media stocks will prove to be the magnets making the Fed's monetary compass malfunction, as oil did in 2008. I certainly hope not, for if so, the modest expectations for growth that I and other investors hold may still prove to be too optimistic. So, to answer the eternal question - to panic or not to panic? - I offer the measured, "It depends on your framework." But I hope you have one, because it may soon be challenged.
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