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.