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.
Sunday, January 25, 2015
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.
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.
Others
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.
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.
Others
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.
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 here, here 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).
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 here, here 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.
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.
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.
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.
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