Tuesday, December 30, 2014

Some Advice For The Real Asset Owners

Much of what I write on this blog is targeted at fellow investment professionals. But it's never far from my mind that our ultimate clients are people who entrust us with the important task of safeguarding and growing their wealth. It bothers me that the asset management industry has started to refer to pension and endowment CIOs as asset owners. Most CIOs are just intermediaries. The real asset owners are the communities and members they serve. So while I don't spend an awful lot of time writing for the retail investor, I recognize that it's a worthy task, and I'm always impressed when someone does it clearly and honestly. A good friend recently asked me how he should be investing his money, and I thought a blog post would be helpful given his impending foray into the married life.

1) Understand the nature of financial assets. Financial assets provide streams of cash that are returned to investors at different points in time. We invest today, hoping to gain a return at some future time. There is a baffling array of financial instruments out there, of which stocks, bonds and real estate are the most common. But thinking about assets as streams of cash helps remove some of the poor thinking that often clouds personal finance. For example, a share of a company is a small claim on the company's future profits, not just a symbol on a stock exchange that miraculously goes up or down.

2) Understand the time value of money. A dollar today is almost always worth more than a dollar tomorrow because of the effects of inflation and the opportunity cost of postponing consumption. When thinking about future streams of cash, we must take this into account. It is the discounted cash flows we care about (i.e. cash flows measured in today's money), not the total cash flows. That said, investing for the long term allows us to harness the power of compounding, which helps small initial sums grow faster than we might expect.

3) Understand valuation. Thinking clearly about the nature of financial assets and the time value of money helps to provide a rudimentary framework for understanding how these assets are valued in a market. It's not uncommon to hear a naive investor say something like "I'm investing in Chinese equities because it's a fast growing economy" or "I'm invested in Apple shares because their iPhone sales are growing rapidly." Even if growth is strong, the market is already pricing in some expectations about future growth rates, profits etc. Always ask yourself, "What are other market participants pricing in?"

4) Understand cycles. Markets facilitate exchange between humans, so it's unsurprising that individual cognitive biases or broad social forces can move market prices to extremes, untethered from reality. We've seen this over and over in financial history. But these cycles present investors significant opportunities if they can strike a middle ground and retain a sense of equanimity.

5) Appreciate uncertainty & randomness. The world is a complex, inter-connected place. Financial markets are inherently volatile and unpredictable, reflecting investor psychology, industry dynamics and macroeconomic policy, among others. Unfortunately, charlatans are only too willing to claim special foresight and skill. Be skeptical of the stories people tell to explain events or their own performance.

6) Understand risk. Given cycles, uncertainty and randomness, outcomes can offer differ sharply from expectations. An appropriate investing framework should give due consideration to the fact that (a) interim fluctuations can be disconcerting, and (b) sometimes even the savviest investors are just plain wrong. Furthermore, all other things being equal, a riskier asset should be cheaper than a less risky one. This is an essential input into valuation, reflected by the discount rate (i.e. how much a future cash flow is valued in today's money). 

7) Investing doesn't need to be a DIY process. But if you're hiring someone, do it right. Any adviser worth his or her salt should demonstrate a keen appreciation of the factors I've listed above. I've written several posts on the characteristics of good investors (see herehere and here, for starters). Also, meet several advisers to get a sense of pricing. It may be worth it to pony up for a skilled adviser or fund manager, but don't forget that small differences in expenses and fees add up to big bucks over the long term through the power of compounding. 

8) Ask advisers how they invest personally. Any fund manager should have a sizable portion of his net worth in his own fund. A financial adviser should similarly broadly follow the tenets he espouses for his clients. If a financial adviser has a markedly different asset allocation than the one he's proposed for you, then you should be asking some hard questions. 

9) Challenge your adviser, but don't make unrealistic demands. Randomness means that short-term performance says little about an adviser's skill. Furthermore, there are times when it is entirely appropriate for your adviser to underperform a benchmark. For example, if financial markets are entering uncomfortably overvalued territory (based on logical, rational metrics, rather than just story-telling), a courageous and ethical fund manager or adviser may well underperform. Conversely, if an adviser or fund manager is suggesting things that you simply don't understand, it's ok to walk away. Perhaps you won't maximize your returns, but you'll hopefully avoid catastrophes and outright fraud.

10) "Gain all you can, save all you can, give all you can." John D. Rockefeller was reportedly a fan of this dictum, typically attributed to John Wesley. While reasonable people can disagree about what constitutes "all you can", the pithy saying holds some hard truths. The process of saving and investing isn't rocket science, but it requires discipline and a willingness to ignore the social pressure of over-spending. A healthy attitude to money is cultivated through conversations with financial professionals, but even more importantly by developing a sensible world-view that recognizes the limits of material well-being. There's no doubt that we have long-term savings goals such as kids' college tuition and health care in old age to save for. But many of us will be fortunate enough to contribute to worthy causes such as fighting childhood malnutrition and disease, or building educational and health institutions in impoverished countries. In a classic case of obliquity, we are likely to be better investors by not focusing excessively on our material well-being, and accepting the uncertainty that investing brings.

I wish you all a healthy, happy 2015 (even if that's too short a period to accurately assess your well-being, not to mention investment performance).

Saturday, December 6, 2014

There's Always Something To Do (On Peter Cundill)

The title of this post comes from a book of the same name on the Canadian value investor Peter Cundill. Frustrated by the lack of opportunities in a rich market, Cundill complained to his friend and mentor, Irving Kahn, who responded, "There is always something to do. You just need to look harder, be creative and a little flexible." This advice seems to have worked wonders for Cundill. His investment vehicle, the Cundill Value Funds, returned 15.2% per annum compounded over 33 years.

I enjoyed learning about Cundill's career and life, though I suspect this may be a bit of a niche read. Reading about a value investor is obviously not everyone's idea of a fun weekend, even though this is a very easy and entertaining little volume. Serious investors may complain that there isn't enough meat or technical detail to keep them engaged. I concede that the book doesn't really delve into the weeds of specific investments, but there are enough stories of investment successes - and even the occasional failure - to keep the reader captivated. The book is based on the personal diaries Cundill kept for over 30 years, and this intimate glimpse into his thinking really separates this book from most descriptions of famous investors. One entry admits, "I am tense because of the lack of performance, insecure and off form, which tends to make me aggressive and adopt a tone that jars." Rather than just reading a paean to a departed genius (Cundill died in 2011), we get to see the challenges of portfolio management, both as a craft and as a business.

Like the best investors and asset allocators, Cundill was fixated with parsing the personal characteristics that laid the foundation for investment success. His list included (1) Insatiable curiosity; (2) Patience; (3) Concentration; (4) Attention to detail; (5) Calculated risk-taking; (6) Independence of mind; (7) Humility; (8) Routines; (9) Physical activity; (10) Skepticism, and (11) Personal responsibility.

I'm surprised that the author didn't include "Flexibility" as one of the characteristics (though perhaps it's subsumed under "Curiosity"). The book's title is, after all, a tribute to the creativity and flexibility investors must sometimes show. An epigram Cundill enjoyed was, "Always change a winning game". Cundill was rigorous in demanding a margin of safety in his investments, usually backed by tangible assets, yet flexible in the application of this philosophy. While primarily an equities investor, he invested in distressed debt as well, including sovereign debt. Cundill was also willing to short markets (most successfully in Japan), though not individual securities. He was also geographically flexible, travelling widely to educate himself on different markets where value had become apparent.

One trait that is certainly mentioned is patience. "The most important attribute for success in value investing", Cundill declares, "is patience, patience, and more patience. The majority of investors do not possess this characteristic." I spent some time in a recent post emphasizing the important of serenity to investors, so this was naturally music to my ears. Patience takes various forms:

1) Doing the homework. "Very few people really do their homework properly, so now I always check for myself."
2) Patience in entering a trade. To use the language of my earlier post, insight is understanding the nature of cycles. Cundill quotes Horace, via Ben Graham: "Many shall be restored that now are fallen, and many shall fall that are now held in honour." Similarly, as Oscar Wilde says, "Saints always have a past and sinner always have a future." Yet insight must be allied with serenity, i.e. the patience to act. Cundill advises, "The trick is to wait through the crisis stage and into the boredom stage. Things will have settled down by then and values will be very cheap again." At the portfolio level, this may often necessitate large cash holdings. This is painful when markets are moving up, but also helps to reduce the likely volatility of the portfolio. I've written about the importance of cash in an earlier post.
3) Patience in evaluating new information, particularly in an era of instantaneous information transfer: "Computers actually don't do much more than make it quicker for investors to react to information. The problem is that having the information in its raw state on a second by second basis is not at all the same thing as interpreting and understanding its implications... Spur of the moment reactions to partially digested information are, more often than not, disastrous."
4) Patience in selling once you're starting to see the price move up. The temptation is to sell quickly, being so relieved that the trade has finally panned out.

The focus on "Routines" can probably be thought of more broadly as "Good Investing Habits". The most obvious of these Cundill practiced was keeping a journal, which allowed him to both reflect upon and document his thoughts. The writer Joan Didion believed that the benefit of keeping a journal is not to document objective reality but to remember how events felt to the individual. It goes without saying that I'm a big supporter of this idea, which drives me to maintain this blog. Another good investing habit was Cundill's practice of visiting the country that had the worst performing stock market in the previous eleven months. This forced him to seek investments outside North America, and extended his natural curiosity. Finally, as a serious marathon runner, Cundill believed that athletic stamina and mental resilience go hand in hand. This runs parallel (no pun intended) to an idea that has piqued my interest, namely Alex Soojung-Kim Pang's concept of "deliberate rest"

Developing these characteristics is hard,but obviously not impossible. Some may be tempted to conclude that nurturing these personal traits, along with the difficulty of understanding financial statements and business models, makes value investing too hard for most people. This is precisely the wrong conclusion. While it is "easy" to follow fatuous investment fads, it is devilishly difficult to make money that way. Cundill's example shows a well-trodden path that requires dedication, but is ultimately a boon to the investor's financial and psychological well-being.

At some points in the book, I found myself questioning if the Peter Cundill way could still be followed. First, many of his investment successes came from recognizing hidden assets in companies. These instances are harder to find today when corporates and activist investors are far more focused on "unlocking shareholder value". Furthermore, previously hidden assets, such as real estate, can now be revalued under IFRS to bring them into the light. The prevalence of such assets in the past made it easier to be a generalist if one could rely on them for value and obtain the underlying business for cheap (or sometimes even for free). Today's investors are generally more likely to have to spend more time on the decidedly less sturdy ground of assessing the durability of economic moats.

All the same, such criticisms do a disservice to the Peter Cundill way. After all, Cundill prided himself on adapting to different markets and investing regimes, rather than repeating the same trick over and over. As he and Irving Kahn would say, there's always something to do.

Monday, November 24, 2014

The Celtic Tiger Falls Into A Trap

The 2006-2011 Irish economic and financial crisis must certainly go down as one of the most dramatic collapses of recent years, despite a litany of strong contenders. Few other crises have highlighted so painfully just how quickly specific problems can morph into Hydra-like catastrophes. In the Irish case, a real estate crisis turned into a banking and financial system crisis, which turned into a fiscal crisis, leading to a sovereign debt crisis and contributing to a regional currency crisis.

I recently finished "The Fall of the Celtic Tiger" by Donovan and Murphy (henceforth D&M). I found it very enjoyable and informative on the specifics of the Irish crisis. The book does an excellent job of laying out the series of events that led to the Irish state guaranteeing the liabilities of its banking system in 2008 and the request for a Troika bailout in 2010. It also comprehensively highlights the role played by different actors in this tragedy, ranging from the property developers and banks to Irish politicians, regulators, media and the public. Few escape the book's critical but balanced gaze.

Somewhat unfairly, I'm going to focus on the book's few weaknesses. There is one actor that gets off too lightly in the book's treatment, in my view. That entity is (no surprises) the ECB. D&M describe ECB banking and credit policy, as well as its role as financial regulator and crisis manager. The narrative, however, gives insufficient due to the ECB's monetary policy decisions - surely the institution's most important function.  

We can break these decisions down into several phases. First, we turn to the pre-crisis period in which the gigantic property bubble was inflating. D&M agree that the ECB's monetary policy did not suit Ireland for much of the 2000s, leading to higher than average inflation, and a sharp loss in external competitiveness. However, they insist that "to "blame" the ECB's monetary policy for the Irish property bubble is to misunderstand entirely the concept of a currency union" since monetary policy should be run for the Eurozone as a whole, not any specific country or region. Furthermore, D&M argue that "it is noteworthy that most of the other Eurozone countries, particularly those in northern Europe, did not borrow on the unprecedented scale that Ireland did. Were their central banks and regulatory authorities more aware of the potential dangers involved and did they discourage it? Or was it a case of different cultural approaches?" D&M seem to settle on "the accentuation of the traditional fixation of the Irish psyche on property" as the key to Ireland's particular mania. 

I agree wholeheartedly that ECB policy should be run for the zone as a whole (even if the reality is that decisions are asymmetric with respect to Germany). But D&M seem to take as a given that Ireland belongs in the Eurozone, despite noting that "this is the second time in twenty-five years that Ireland has faced major economic and financial difficulties. Bernard Connolly's excellent "The Rotten Heart of Europe" reveals the paucity of reason behind Ireland's decision to join the currency union. Rather than resorting to cultural reasons, D&M seem to have underplayed the fact that Irish nominal GDP was running far, far too high from 2001-07. 

You can look at the Google Data visual depiction on your own if interested. I concede that Ireland's deviation from a healthy NGDP trend was not the ECB's "fault" per se, but rather the inappropriateness of a one-size-fits-all monetary policy, which D&M underplay.

We next turn to 2008. Few central banks covered themselves in glory in understanding the interaction between tight money and economic and financial collapse. The ECB, of course, was particularly culpable in raising rates in July 2008.

As a financial regulator, the ECB compounded this mistake. As D&M note, "while not prepared to embark on any specific rescue package for a country in difficulties, [the ECB] opposed strongly any suggestion of the country in question allowing its banking system to default." It is particularly curious that European authorities such as the ECB are very keen on protecting domestic banking structures despite moral hazard risk. Yet they spew jeremiads about that risk when dealing with sovereigns.

2008-2010 offered another phase of the Irish crisis, after the banking guarantee. D&M correctly note that "periodic upward revisions of the extent of the banking disaster contributing to an underlying erosion of market confidence". Yet the ECB seems to escape any criticism for this state of affairs. Its overly tight monetary policy did little to assuage the effects of a broad deterioration in European banking. What's worse, the correspondence between Finance Minister Brian Lenihan and ECB President Trichet shows the ECB's deep and unhealthy involvement in Irish political economy. It is laughable that some "sound money" types in the US have praised the ECB for its rigid adherence to (if unsuccessful achievement of) its inflation targeting mandate. The ECB, as I have underscored before, is an intensely political beast - far more so than the Federal Reserve. 

Finally, we come to the post-2010 period. D&M rightly state that "the absence of any significant GDP growth has rendered the achievement of deficit/GDP and debt/GDP targets that much more difficult", but do not point to the ECB for its role. The infamous 2011 rate rises are the worst example of the ECB's performance, which has compounded Ireland's difficulties. Again, in highlighting the ECB's mistakes, I do not want to exonerate the other actors who D&M do such an excellent job of identifying. There would have been a collapse in Irish property prices even without the ECB's raft of mistakes. But these errors - and the general inadequacy of the Euro for its members - must surely be cited.

To end, I want to draw one major lesson from D&M's generally excellent treatment of this crisis, namely that understandable emotions are the enemy of good economic policy. First, the decision to join the European Monetary System in December 1978 led to the breaking of the one-to-one parity of the Irish pound with sterling in March 1979. The breaking of parity "was perceived as representing a symbol of success as a nation."  Yet this desire to be free of the UK's influence led eventually to the property bubble by yoking Ireland to the ECB. And of course, this unfortunate manifestation of nationalism was equally apparent when the bailout occurred. In Nov 2010, the Irish Times asked whether the men of 1916 had died for "a bailout from the German Chancellor with a few shillings of sympathy from the British Chancellor on the side... the shame of it all." As D&M write, "The loss of sovereignty was palpable."

If national pride is a bad guide to economic policy, empathy is equally to blame. D&M write that "The roots of the Irish fiscal disaster were initiated by a political decision, implicitly shared by all political parties, that the fruits of the boom should not be confined to those involved directly in property." An understandable desire to share the bounty of good fortune (or perhaps the opportunism of politicians) led to disastrous fiscal decisions, weakening the government's finances right when they were needed the most.

All in all, D&M do a superb job of explaining the Irish economic and financial catastrophe. While there is a human tendency to want to blame individual actors or identify specific causes, D&M show cogently how the Celtic tiger fell into a trap that it is still struggling to escape.

Monday, November 17, 2014

Serenity, Insight and Investing

I've been reading Bhikku Bodhi's "In the Buddha's Words", which is an anthology of discourses from the collection of Buddhist scriptures known as the Pali Canon. The message is simple but powerful: "From development of the mind arise happiness, freedom, and peace." He goes on, "Development of the mind... means the development of serenity (samatha) and insight (vipassana). Both serenity and insight are considered necessary to achieve true development. "The cultivation of serenity requires skill in steadying, composing, unifying, and concentrating the mind. The cultivation of insight requires skill in observing, investigating, and discerning conditioned phenomena...While meditators may [approach the two aspects] differently, eventually they must all strike a healthy balance between serenity and insight."

While these precepts form the foundation of one of the world's major philosophical traditions, one does not need to be a Buddhist to see their broad applicability. Stoic philosophy conveys similar ideas. Closer to the current day, Jonathan Haidt's "The Happiness Hypothesis" presents another metaphor, that of the elephant and the rider. The mind is divided between conscious/reasoned processes and automatic/implicit processes. These two parts are like a rider atop an elephant. The rider's inability to control the elephant explains many puzzles about our mental lives. Haidt posits that learning how to train the elephant is key to self-improvement.

Unsurprisingly, I think these ideas provide a useful philosophical basis for the tiny sliver of life that is investing. I've written before about Robert Hagstrom's view of investing as the last liberal art. Investors need a grasp of (in order of least controversial to most controversial) finance, microeconomics, macroeconomics, psychology, history and sociology. All these contribute to insight, i.e. seeing the financial markets as they really are, and being humble enough to create a risk management framework that deals with the uncertainty inherent in investing. Developing insight is certainly more than just being knowledgeable, particularly in this era of Information. It's about trying to develop wisdom. To quote T.S. Eliot, "Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information?" It's easy to mistake information for knowledge, and knowledge for wisdom. 

That said, even wisdom seems to only be part of the equation. One can be a brilliant analyst but lack the equanimity and humility required to translate good ideas into successful investments.Serenity allows the investor to actually implement an investment, and to maintain an even keel whether things are going particularly well or particularly badly. Anyone observing financial markets comes to realize that they just another medium conveying the vicissitudes of human life. Fear and greed are rightly identified as two emotions that drive much of how we act in financial markets. But market participants experience other emotions too: for example, they experience anger, disgust and shame when taking losses, trust and pride when things appear to be going well, and confusion when market action goes against expectations. The skilled investor therefore needs to be master of his own emotions. Despite his homespun image, Warren Buffett too merges investing acumen with a steely constitution, and the combination has led to his stellar record. Stan Druckenmiller is more of a trader than a value-oriented investor, but my former boss Scott Bessent, in "Inside the House of Money", describes Druckenmiller's toolkit as such: "Stan may be the greatest moneymaking machine in history. He has Jim Rogers' analytical ability, George Soros's trading ability, and the stomach of a riverboat gambler when it comes to placing bets." 

The emotional component to investing is well-recognized these days, with books like Kahneman's "Thinking Fast and Slow" popularizing behavioural economics. Kahneman uses the terms System 1 and System 2 to represent fast, unconscious thoughts and slow, effortful thoughts respectively - analogous to Haidt's elephant and rider respectively. But despite Kahneman's literary success, my guess is that investors still pay far less attention to this side of investing than they should. While there are numerous mainstream avenues to develop the analytical tools of investing (again, just one part of insight, in my analogy), such as going to business school or getting the CFA qualification, these tools are not worth very much without a sound emotional grounding. In fact, they can even be harmful, creating the illusion of certainty where none exists. 

Sadly, there aren't schools devoted to helping investors gain the type of serenity they need. Most investors (retail and professional) succumb to those old enemies, fear and greed, far too often, leading to sub-optimal investment performance. Perhaps we all need to take a step back to learn from Druckenmiller and Buffett - and maybe even the Buddha.

Wednesday, October 22, 2014

Are You A Value Investor, Or Just A Cheapskate?

There's a big difference between being a value investor and merely being a cheapskate. The dictum goes, "Price is what you pay; value's what you get." To the skilled investor, value reflects the exploitable wedge between price and value. It's a relative concept, rather than an absolute level. This is often hard to remember because we use the same words - "cheap" and "expensive" - to describe two concepts. Something can be cheap relative to its inherent qualities, or cheap in an absolute sense, which is to say selling at a low dollar price. It's often helpful to clarify which people mean.

The father of value investing, Ben Graham, was occasionally unclear on this point. His most famous disciple, Warren Buffett, notably adapted his investing style to incorporate quality as a component of value (influenced by Charlie Munger). In fact, Graham almost made a gigantic error by being a cheapskate rather than a value investor. Buffett recounts, "I offered to go to work at Graham-Newman for nothing after I took Ben Graham's class but he turned me down as overvalued. He took this value stuff very seriously!" Buffett might just be being kind here - if I recall correctly, I've read elsewhere that Graham turned Buffett down because young Jewish men were being barred from so many places on Wall Street that he felt inclined to save spots for them to work at Graham-Newman. But at any rate, the thought of Graham turning away the bright young Buffett seems like an act of folly. 

The distinction between value investing and being a cheapskate applies to regular life too. I posted about a month ago about this paper by Bronnenberg, Dube, Gentzkow and Shapiro that found 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 marketing and therefore opt for a lower priced product with the same efficacy.

About a week after writing that post, I found myself choosing between a brand name health product costing $90 and a generic brand at $60. "Screw you, brand name," I proudly thought. "I've read my BDGS." Big mistake. Three weeks later, I discovered the product wasn't working, and was forced to cough up for the more expensive alternative.  

Really, I made two mistakes. First, I incorrectly extrapolated the BDGS finding from the relatively narrow world of headache remedies to a completely separate product. Second, the BDGS finding referred to informed consumers. Alas, that's not me. I'm just a guy who heard a podcast and read a paper. I believed I'd found an exploitable wedge between price and value - and I was wrong.

Thankfully the mistake was minor, and reversible (well, I hope so!). Investing forces us to be both arrogant and humble at the same time, believing that the multitude of investors we call the market is wrong, but being conscious that we might be wrong. The world is full of value traps - investments that look "cheap" but are not. Equally, there are opportunities that appear expensive, when in fact the odds of success and future cash flows are sufficiently favourable as so offset a purportedly high price. I credit Charlie Munger and certainly Phil Fisher for clarifying my thinking on this point. Similarly, value investors sometimes take pride in being thrifty or being out-and-out cheapskates in their daily lives. That, I believe, is a big mistake. Knowing the difference between price and value is a crucial component of value investing - and indeed life. 

Saturday, October 11, 2014

It's Not Time To Worry Yet; They Won't Do It Again

In Nov 2002, Ben Bernanke, then a member of the Fed Board of Governors, gave a speech to honour Milton Friedman's 90th birthday. In the speech, Bernanke summarized the findings of Friedman and Schwartz's work on the Great Depression, concluding that "Monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, "a stable monetary background" - for example as reflected in low and stable inflation." He famously ended, "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

Less than 2 weeks later, Bernanke gave another important speech at the National Economists Club, entitled "Deflation: Making Sure "It" Doesn't Happen Here". While the first speech covered historical episodes of monetary-induced volatility, the second focused on future policy prescriptions to combat deflation, countering in particular the notion that monetary policy was impotent at the zero lower bound (ZLB).

(Aside no.1: It's interesting that these two speeches, arguably the best-known of Bernanke's speeches, were given within 2 weeks of each other. As a Fed Governor, Bernanke was in the sweet spot of being able to be relatively candid while having access to the highest corridors of power. Most of his later speeches are necessarily more cautious, and are understandably less objective since they, to some extent, have to defend decisions that he and his colleagues took.)

(Aside no. 2: Wikipedia tells me that Bernanke is married to Anna Friedmann, confirmed by the NYT. I guess Friedman & Schwartz's work had an even bigger impact on Bernanke than he knows. Milton Schwartz was his next option.)

If you've never read the speeches, or if it's been awhile since you last read them, I encourage you to spend 30 minutes (I'm a slow reader) and marvel at their lucidity and prescience. Reading them isn't merely an academic exercise. For investors, the first would have warned you of the potential impacts of the ill-fated decisions in 2008 to focus on inflation. The second laid out the Bernanke playbook, and could have helped you understand the possible rebound in economic performance and asset prices. It's easy to say that in retrospect, of course. But I find it interesting to go back to these speeches as we wrestle with another question: Will we see another 2008?

The answer to this question depends a great deal on one's reading of the causes of the 2007-2009 conflagration, and deciding if similar conditions are in place. You don't have to look far to find those worrying about the fragility of the financial markets. Noted bear John Hussman wrote recently, "I view the stock market as likely to lose more than half of its value from its recent highs to its ultimate low in this market cycle." A host of savvy investors, most pertinently Seth Klarman, have expressed their concerns about market valuations and sentiment. There are also those like the excellent SoberLook.com who look at this chart of investor sentiment (from Yardeni Research) and conclude that there isn't enough bearishness in the market

And of course, the Fed has voiced its concerns about valuations in tech stocks and the leveraged loan market recently.

I haven't exactly been a bundle of optimism this year, worrying that the Fed is extremely unlikely to allow (or generate) a boom that would make up for some of the lost growth of the past 7 years. And I agree there are many reasons to be bearish - the Fed concluding its asset purchase programme, the seemingly intractable problems in the Eurozone, slow relative growth in the Chinese economy, and a plethora of geopolitical conflicts.

But still, I have to say, I just don't think conditions are the same for another meltdown. My quick summary of 2007-2009 is as follows: a serious financial crisis occurred due to lax credit conditions, poorly understood financial instruments, and inaccurate beliefs about risk. This interacted in powerful and catastrophic ways with serious monetary policy errors to produce an economic and financial spiral.Specifically, there was an inappropriate focus on inflation at the expense of growth, compounded by paralysis when confronted with the ZLB.

The situation today seems a little different:

(1) Sentiment does not seem as optimistic. There may be fewer bears, but there are fewer bulls as well. I don't think it's realistic to say that we've gone back to the go-go days of the Dotcom bubble or 2007. Investor psychology was profoundly altered by the experience of the dark days of 2008 in particular. Yes, 7 years later, the memories have faded a bit, but I simply don't buy the argument that investors are ready to throw caution to the wind. Are there sectors that are overvalued? Almost certainly. But that's how markets work. 

(2) The policy landscape is completely different. The psychological barrier of breaking $100 oil has long been shattered, reducing the risk of inflation-phobia. Far more importantly, the playbook of tools for easing at the ZLB has been firmly established. In his speech on deflation, Bernanke pointed out that "an essential element [of taming the inflation dragon] was the heightened understanding by central bankers and, equally as important, by political leaders and the public at large of the very high costs of allowing the economy to stray too far from price stability."A similar story applies to easing at the ZLB. There was a story in the news today about the Bank of Israel (which has been extremely innovative in the past few years) being willing to consider unconventional tools should rate cuts fail to achieve the inflation target. Stories like this no longer even make us bat an eyelid. Yes, the ECB is struggling to implement QE, but that's for political reasons. I accept, and worry, that there are short-term risks that the Fed would be relatively slow to reverse its tightening course even if serious global shocks occurred. But another 2008 simply doesn't seem to be in the offing.

One of my favourite quotes (from one of my favourite books) is Atticus Finch's refrain "It's not time to worry yet" in "To Kill A Mockingbird". I suppose that Finch-ism captures how I feel about the state of the equity markets in particular. Successful long-term investing requires discipline - discipline to ride out periods of volatility, and discipline to take advantage of ebbs and flows in investor psychology. That's the best way I know to harvest risk premia over the long run.Of course there are times to worry, particularly when no-one else seems to be doing so. But for the time being, I'm taking the Fed at its word that, thanks to Milton and Anna, they won't do "it" again.

Thursday, September 25, 2014

See Ya Later, Allocator

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.

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.

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.

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. 

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.

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.

Thursday, July 3, 2014

Normal Service Will Resume...

...after Jul 16! Breathe easy.

Sunday, May 18, 2014

The Quest For An Investing Moral Compass

I have cheekily (some may say unoriginally) adapted the title of a new book by Kenan Malik for the title of this post. Unlike Malik's book, this is by no means a treatise on an ethical approach to investing, but rather a collection of thoughts that will continue to be refined through experience and discourse. As Malik says in his introduction, "In the modern world, morality is inseparable from choice." Earlier this week, I finished Kurt Eichenwald's excellent Conspiracy of Fools, which narrates the rise and fall of Enron. Mercifully, scandals on the scale of Enron happen infrequently, but I was struck by how many people were complicit in its collapse through indifference to detail, fears for job security and subservience to presumed expertise (as opposed to those driven by outright greed & intent to defraud). 

The world of investing, as we know from the likes of Bernie Madoff, is equally fraught with such moral decisions. More subtly, investors make implicit ethical choices by investing in companies or asset classes, or even by settling on different investing strategies. (If this sounds impossibly sanctimonious, I wish I had some folksy, homespun Buffet-isms to help, but they would probably sound pretty ridiculous coming from someone from Singapore). Bodies like the CFA Institute attempt to sketch out guidelines for financial professionals' "fiduciary duties", but these can never cover the complex interaction of real-world investors and clients. Fiduciary duty can only be described vaguely as "doing what's right for one's client". I list some examples below of possible areas of ethical conflict for those engaged in the purchase of securities or allocation to managers and strategies:

1) Is it ethical to invest a new dollar for a client if you believe a market is overvalued? Inflows from clients (particularly retail) are notoriously pro-cyclical, which suggests that you are very likely to be receiving new capital late in the game when valuations are stretched. Some PMs seem to take the view that investors have given them a mandate, and that they should then meet that mandate by investing in ideas that can outperform a benchmark, thereby achieving relative, if not absolute outperformance. Their clients, they argue, are not paying them to hold cash. I, on the other hand, think there are plenty of times when it's more appropriate to hold cash, and consider it another asset class. I understand well that the pressures of running a business often compel investors (particularly long-only funds) to be fully invested at all times, but this strategy seems doomed to the occasional (and possibly fatal) blow-up. 

2) The recent decision by Stanford University's endowment to divest from coal-related investments has renewed (no pun intended) the debate on socially responsible investing. The investor's role is obviously to make the highest return possible for his client within a socially acceptable framework of risks and care for society and other stakeholders, but delineating that framework is tricky. Stanford has reportedly kept its stakes in oil & gas companies because of a lack of alternatives for those fuels. A cynic might plausibly suggest that given the growing prospects of natural gas and renewables, the likelihood of explicit or implicit carbon taxes in the future and the poor returns on coal-related equities, Stanford has simply decided to take its lumps on its coal holdings (ok, I meant that one). Arguably, a socially motivated owner could do more good by pushing his company to engage with regulators more keenly, rather than merely selling his stake. 

3) This one might be the most controversial of the three. I've been listening to a lot of Michael Covel's podcasts lately on trend-following strategies (the longer interviews often feature interesting guests; the shorter ones seem less worthwhile). I recognize the potential for profitable trend-following/momentum strategies (right on cue, AQR has contributed its intellectual heft in defense of momentum investing), not to mention other technical strategies as laid out for popular consumption here by Andrew Lo and Jasmina Hasanhodzic. Mind you, an investor doesn't have to have an exclusively technical framework to be a momentum investor - as George Soros famously said, "When I see a bubble forming I rush in to buy, adding fuel to the fire." Yet one of the supposed benefits of a market is that it generates prices, which in turn provide information about the allocation of resources. I've seen it said that Soros used to say of his speculating, "I shouldn't be allowed to do what I do, but I'll do it as long as I'm allowed." That seems an amoral escape route, and one I suspect Soros himself has largely abjured in his later incarnation as global statesman. One can often make a good deal of money pushing up the price of an asset from fair value to overvalued levels before offloading to an unsuspecting patsy, but that hardly seems like a socially defensible form of investing, philosophically indistinct to me from other forms of legal but unethical business practices. But before I sound like I'm on my high horse and ready to break into canter, let me say that this somewhat ideological notion of contributing information to the market can be taken to extremes. Those dogmatically opposed to market exuberance would have been shorting Internet stocks in early 1999 and eventually cast in the sea of bankrupt investors in a shroud of ideological purity. Logotherapy is best saved for the therapist's couch, and shouldn't be bankrolled by one's clients. I'm sure there are some Herbalife investors out there who agree on that count. All told, it can be difficult discern whether and to what extent an investor owes a duty to society as a whole.

As I said, this is by no means an exhaustive survey of possible ground for ethical dilemmas in investing, but a recognition that these quandaries exist. I look forward to comments.