Sunday, January 25, 2015

Our World Of Risk

The 9/11 Memorial Museum in New York City is a moving tribute to a tragic episode in the city's history. It's also incredibly extensive. I planned to spend two hours there, and ended up spending four. Part of that was my own interest in the event, having lived in New York for many years (albeit well after 9/11). But another reason for the length of my visit was the surprising nuance and richness of the exhibits. I was pleased to see that the museum didn't shy away from presenting uncomfortable issue that resulted from 9/11, such as a series of expensive wars of debatable efficacy, the rise of anti-Muslim sentiment globally and in the US, as well as threats posed to individual civil liberties. It was also another reminder of the concepts of reflexivity and the risk society. I refer here not to the concept popularized by George Soros, but rather its use by sociologists Ulrich Beck and Anthony Giddens. To simplify greatly, Beck and Giddens described our modern world as being a risk society, in which (a) we devise methods of dealing with the hazards and insecurities created by modernization itself, and (b) respond in turn to risks created by those supposed safeguards. The idea of a feedback loop has obvious parallels to the Soros concept, since both iterations are founded on ideas developed by William Thomas, Robert K. Merton and Karl Popper.

9/11 clearly demonstrates the risk society at work. 19 men were able to turn the fruits of modernization (airplanes and skyscrapers) into weapons of mass murder and terror. In response, the US and its allies launched a global "war on terror" that at the least inconveniences us as air travellers, and in its worst form seems to have resulted in the torture of suspected terrorists, giving fuel to anti-Western sentiment. 

This certainly poses problems for those attempting to be thoughtful citizens. While we may hope to be rational and well-informed about political issues, it is incredibly difficult to do an informal mental cost-benefit analysis. Indeed, one of the best guides to public policy is still Bastiat's urging to consider "that which is seen, and that which is not seen". Take national security for example. Its very nature prevents citizens from ever learning the full extent of threats or the cost of steps taken to deal with those threats. So how can citizens assess whether increased safety has merited the extraordinary costs (as the Cato Institute asks here)? These costs refer not only to the financial outlay combating terrorism since 9/11, but also the possibility that terrorism is better allayed by supporting poverty and disenfranchisement across the globe. 

Climate change offers another example of the challenge of being a citizen in today's risk societies. It seems to me that reasonable people can argue as to the urgency of the climate crisis, and how much should be done to prevent further man-made climate change (for example, see Matt Ridley on being a "climate lukewarmer"). 

Nassim Taleb suggests the use of the "precautionary principle" in such matters. Essentially, he and others argue that if an action or policy has a suspected risk of causing harm to the public or to the environment, in the absence of scientific consensus that the action or policy is not harmful, the burden of proof that it is not harmful falls on those taking the action. I'm not quite sold on this. He raises the question of drugs such as Vioxx, which reportedly caused 88,000 heart attacks and 38,000 deaths in the US. While Vioxx is a tragic and horrific story, the "seen and unseen" dictum creates complexity, in that there are presumably many people who deteriorate or die from drugs that are held up from approval. 

Let me move from national security issues to security issuances (geddit?). Taleb is certainly known better for his writing on financial and economic risk, and I quoted him in an earlier post on risk. A recognition of black swan events leads to an emphasis on robustness (or even anti-fragility). Last week brought a reminder of the importance of robustness: The Swiss central bank decided to remove its de facto peg to the Euro, causing several hedge funds to shutter after suffering heavy losses. Retail FX investors similarly learned the pitfalls of 50:1 leverage when a currency moves 28% in a day. 

I don't want to make this post longer than it already is, so let me end with some brief comments on how to increase robustness in one's financial portfolio

(1) Recognize sources of leverage. Leverage introduces fragility into one's financial position. Besides explicit leverage (that is, the borrowing of money to finance an asset), there is implicit leverage in businesses through high fixed or total production costs (operating leverage).
(2) Be reasonable about one's knowledge. A long familiarity with a name or industry should decrease (though never eliminate) the unknown unknowns over time. Again, this lends itself to sticking within one's circle of competence 
(3) Think about asset correlation, but realize these correlations can change in a globalized, financialized world. 
(4) Size positions accordingly, in line with points 1-3.
(5) Be committed to learning appropriately from mistakes. Learning not to repeat mistakes is an example of Taleb's anti-fragility, since the individual or organization grows stronger from small losses. But we can sometimes take away too much from mistakes, as Ed Catmull learned when dissecting Pixar's missteps

None of this requires fancy quantitative methods, as I argued in my earlier post. It does require common sense and humility to recognize that the world is viciously unpredictable. There's no use lamenting this fact. But we can take steps to prevent ourselves - or at least our portfolios - from being buffeted by our world of risk.

Thursday, January 15, 2015

Commodity Isn't A Dirty Word

Warren Buffett popularized the metaphor of the economic moat to describe a firm's competitive advantage. As quoted in what I consider one of the best articles on the topic, Buffet explains, "What we refer to as a "moat" is what other people might call competitive advantage... It's something that differentiates the company from its nearest competitors - either in service or low cost or taste or some other perceived virtue that the product possesses in the mind of the consumer versus the next best alternative... There are various kinds of moats. All economic moats are either widening or narrowing - even though you can't see it."

Assessing companies' economic moats is generally considered sound practice for investors of all stripes. Value adherent Glenn Greenberg (of Brave Warrior Capital, and formerly of Chieftain Capital) urges the discriminating investor to "single out truly good businesses". In a similar vein, growth investor and writer John Train summarily lowers a scythe on a large class of investable equities, saying "I would avoid the large, cyclical industries even if they are supposed to be ripe for an upward swing." Instead, he exhorts us to invest in oligopolies and growth industries. Finally, noted entrepreneur and venture capitalist Peter Thiel states flatly, "You always to want to aim for monopoly and you always want to avoid competition... Competition is for losers."

I have no arguments with the importance of a company's economic moat to its ability to generate returns. However, I don't feel the need to invest only in truly magnificent businesses. This seems to shrink the universe of investable companies quite meaningfully. Furthermore, it introduces the risk of overpaying for an economic moat. Investors often tout the "high quality" of their portfolio companies, which is generally shorthand for high and predictable returns on invested capital. But this quality rarely comes cheap. You'll never lose your portfolio management job owning "quality" names, but returns may be disappointing. Finally, I'm hesitant to label a company "high quality" since it seems to imply that this quality is inherent and immutable. As Buffett correctly notes, one's moat is constantly widening or narrowing. Train similarly warns readers, "Beware of the company with a franchise that has turned into a commodity." 

Perhaps the solution is declare oneself a MARP investor - Moat At Reasonable Price. But I think it might be even easier to realize that the lines drawn between different investing styles are often quite arbitrary. I'm often reminded of this when I look through the countless products peddled by investment management firms. At the heart of it, all investors are presumably trying to buy stocks that are cheap relative to their future prospects. Why not, then, remain style and industry agnostic? The value of every asset is the sum of discounted cash flows, whether those cash flows are growing fast or slow, or whether they are steady or cyclical. Two caveats: (1) Value is admittedly better thought of as a range rather than a single number, and (2) Investors are well-advised to develop a deep understanding of several industries, and admit when a valuation project simply appears too difficult. But this doesn't negate the basic point that there are times when value-oriented investors would be wise to consider cyclical stocks fair game. In his interview for a book on global macro, Ospraie Management's Dwight Anderson demurred, "We are global micro, not global macro. What we do is pure Microeconomics 101: supply and demand, identifying which companies are low cost, which have cash, and so on. We are constantly striving to understand the changes in our industries: how the composition of demand is changing, how the cost curve is changing, what currencies are doing to change the cost curve, and who the competitive players are." (I have to concede that Ospraie had serious issues in 2008, but this should not be seen as an indictment of the whole strategy of investing in commodity-related firms. Perhaps they swung too far in ignoring global macro.) 

This seems particularly relevant given the collapse of commodity prices that has occurred over the past 18 months, and the concomitant decline in equity prices of firms in the sector. While the press seems obsessed with deciding when and at what price crude oil will bottom, this should be of less importance to a fundamental investor. It is far more important to ascertain a likely range of commodity prices in the medium term, and understand how this price scenario will affect a company's cash flows and balance sheet. There's little doubt that low-cost producers with strong balance sheets will be survivors despite the inevitable fluctuations of commodity prices. These turn out to be the moats needed to survive in cyclical and economically sensitive industries. Dwight Anderson is very clear on this point, cautioning, "You can't buy a high-cost asset cheap enough... When you have a high-cost asset, you have to get the price and the timing right... we will only invest in low-cost companies because we don't have to get the timing right." 

In describing the "Washout Phase" of a stock market cycle, Train notes that this is when "the really big money shows its hard...Mr. Getty buys a string of oil companies for two times cash flow." We don't appear to be there yet and Mr. Getty is no longer with us, but the revulsion against owning commodities suggests we're getting closer. In the meantime, patience is required, as is the occasional gentle reminder that "commodity" isn't a dirty word.

Monday, January 12, 2015

Books I Enjoyed In 2014

Regular readers of this blog will know that many of my posts are sparked by books or articles I've read. I thought it might be helpful to put together a short list of things I particularly enjoyed in 2014. While I've restricted the list to things I read for the first time in 2014, it must be said that I vastly prefer reading old classics to newer but less memorable tomes. I recently decided to pack up roughly 1/3 of the books that I own since I saw very little likelihood I would re-read them in the next 24 months. Of the remaining 2/3, I estimate I have yet to read 40% of the titles - but I'll get there! Still, there's no way to discover new favourites without breaking some new ground, so here's the 2014 list.

Business, Finance & Economics

Creativity, Inc: Pixar's Ed Catmull recounts how the company was built. An enjoyable look at the origins of this path-breaking company, and also very informative in thinking about how creative organizations can be nurtured. I wrote about it here

Salt Sugar Fat: Part history of the food industry, part expose of its unseemly practices to hook us on unhealthy foods. Like Jonathan Safran Foer's "Eating Animals", it truly changed how I view food and how I eat. It also made me think hard about equally unethical practices in the financial services industry.

The Second Machine Age: MIT professors Brynjolfsson and McAfee follow on from their previous work describing how technology is changing our economy, and how it will affect us as consumers, producers and workers. One of the greatest challenges is avoiding "this time is different" thinking while appreciating when genuine secular change is in the works. 2MA raises as many questions as it provides answers. 

Conspiracy of Fools: The story of Enron's rise and fall is well-known, but this account reads just like a thriller. The combination of greed, corruption, stupidity and fear of standing out is breathtaking, as is the juicy array of characters.

The Rotten Heart of Europe: Regular readers will know I'm often bearish and sometimes just plain confused about the future of the Eurozone. Connolly's book talks mainly about the cracks that were visible in the European project well before the European Exchange Rate Mechanism came to pass (predating the ongoing Euro crisis). Remarkably prescient about the crisis, and skillful in describing the politics and economics behind the flawed idea. I wrote about it here

And The Money Kept Rolling In (And Out): I'm a huge fan of Paul Blustein's work, and this work on the collapse of Argentina in the early 2000s is as good as I'd expect from him. It was particularly pertinent in 2014 as Argentina's sovereign debt woes continued, a legacy of the era Blustein recounts so skillfully.

The Life You Can Save & The Great Escape: It may surprise some to see Singer's "The Life You Can Save" under the Business, Finance & Economics heading but dealing with poverty is obviously an economic issue as much as a moral one. Singer's book will appeal to those who want to think clearly about how to do the most good with limited time and resources, and resonated deeply as I considered my long-term financial and life priorities. However, I disagreed with Singer's mechanical view of the economy where simple redistributions from rich to poor would create the best outcomes. This is a theme Princeton professor Angus Deaton takes up in "The Great Escape", which is a superb account of global trends in health and material well-being. Despite what appears to be a left-leaning bias, he is tepid on foreign aid and external intervention. Empathy has to be tempered with the fact that a true "Great Escape" can only occur when countries have strong organic institutions to engender postive health and economic outcomes.

Pioneering Portfolio Management: David Swensen's shepherding of the Yale endowment is the gold standard in institutional investing. Here, he describes how Yale does what it does (and doesn't shy away from attacking foolish and unethical practices in the financial industry). Of course, it must be taken with a grain of salt since not all institutions have Yale's resources and clout.

Measuring The Moat: Not a full-length book, but I loved the way Maubossin and Callahan combined a deep understanding of strategy and finance in this piece to explain how companies produce returns. This should be required reading for management and investment professionals alike.


Make It Stick: I'm always trying to learn about learning, and this book is absolutely terrific. I gained so much from the authors' explanations of the science of learning, which is conveyed in an accessible and memorable manner. Keeping this blog going is, in part, a reflection of some of the lessons learned from this book.

The Great Agnostic: Susan Jacoby does a superb job in bringing Robert G. Ingersoll back to the forefront of American intellectual history. Ingersoll's writing and speeches are magnificent to behold, but what's most impressive is how a contrarian streak and devotion to truth led him to the right side of many issues before his contemporaries.

Naked Statistics: If you're like me and have forgotten quite a bit of what you learned in high school/college statistics courses, Whelan's book, focusing on the intuition behind statistical thinking, is for you. We live in a world inundated with data and "statistics", so this is helpful in trying to separate fact from fiction. Whelan's humourous and accessible style had me laughing throughout - no mean feat for a book on statistics.

Hunting Eichmann: Fascinated by WWII? Of course you are. My interest was reignited after a trip to Auschwitz this year, and the story of Adolf Eichmann was particularly compelling. One of the central figures in conducting the Holocaust, Eichmann eluded capture for 15 years before being kidnapped by the Mossad in Buenos Aires. I learned a lot about the history of modern Israel, as well as Argentina's status as a Nazi haven post-WWII.

Marked: I have long been interested in the issue of returning formerly incarcerated people to the workforce, but Devah Pager's superb and creative sociological study reveals the challenges this group faces. Prepare to be shocked at the magnitude of this problem.

On China: I had this book on my shelf for 2 years before finally getting to it, and truth be told, may never read this massive tome again. But Kissinger's history of China, with a focus on foreign policy, is quite fascinating. Today, we take China's rise as a given but it's always worth remembering the domestic and international political environment necessary to allow those far-reaching economic reforms to unfold. 

In the Buddha's Words: "Mindfulness" is all the rage in the West these days, but this anthology compiles the Buddha's original teachings from the Pali Canon in a thematic fashion. It seems only right that we should seek truth wherever it may be found, and the power of these teachings resonated deeply with me as a secular humanist (as opposed to a "religious" Buddhist). Naturally, I managed to connect these ideas to investing here.

Honourable Mention

The Euro Crisis and Its Aftermath: If you need a primer on the Euro crisis, Jean Pisani-Ferry has done a terrific job here.

Beyond Debt: Similarly, Nikos Tsafos has done a good job bringing together the various strands of the Greek crisis in a single volume.

Risk Savvy: I'm a big fan of Gigerenzer's work. I'd heard much of this in prior books and speeches, but he always challenges me to go against some of the biases I hold, and to try and think more clearly about risks.

The Masters of Private Equity and Venture Capital: I read this in preparation for doing some consulting work to the PE industry, and enjoyed the easy style of the interviews, along with a good introduction to how some of the industry's top minds think. I wrote about it here

There's Always Something to Do: This is a short and enjoyable biography of the Canadian value investor Peter Cundill. While short on the nitty-gritty of specific investments, there is enough here to entertain students of the value investing niche. I wrote about it here.

The Fall of the Celtic Tiger: I'm sure you've figured out by now that I'm fascinated by financial & economic booms and busts. Ireland's particular foray into this genre is explained well by Donovan and Murphy. I wrote about it here.

The Accidental President of Brazil: I really enjoyed these memoirs of Fernando Henrique Cardoso, who should be credited with Brazil's recent rise to prominence (a legacy his successors seem intent on squandering, unfortunately). The only reason this didn't make it to the main list is that I only read selected bits on Brazil's defeat of hyperinflation. I'm sure I'll read the whole thing at some point. I wrote about it here, here and here.

Man's Search For Meaning: This is partially a memoir of psychologist Viktor Frankl's time in Nazi concentration camps, and partially a discourse on his system of logotherapy, which proposes that the primary motivational force of an individual is to find meaning. I read this just before visiting Auschwitz and was deeply moved.