An Investment Confessional

Since the market low in March of 2009, I have not managed to keep pace with the passive return of the S&P 500 index. In no year in the last 8 have I met or exceeded the return of the index on a portfolio-wide basis. I would’ve been much richer by now if I had just turned my capital over to Mr. Market almost a decade ago and spent my time and energy worrying about anything but investing.

And I managed to do this primarily by being uninvested throughout this time period. I have not gone back and done a trade-by-trade and year-by-year study of my portfolio returns over this time period (I am including here my personal accounts as well as other accounts I manage) but just eye-balling it I think it’s safe to say the most exposure I’ve ever had to equities over this time period was no more than 25% of any of the portfolios and probably a lot closer to 20% on a gross capital basis. In essence, I sat out one of the biggest bull markets in history and missed an opportunity to capture a 271% total return through passive management. That’s something like 18% a year, an impressive long-term rate of return by most standards.

How did I manage to let this happen? And what have I learned from this experience? More importantly, what do I plan to do differently going forward?

The story of this mishap is complicated in my mind and is over ten years in the making. I was aware of the stock market as a concept since my early teenage years. On Friday nights after dinner my family would watch a battery of shows on PBS including “Wall Street Week with Louis Rukeyser.” I learned nothing about investing from watching this show other than there was this place called a stock market and people had a lot of opinions about what was happening there. My father was no investment guru and my clearest memory of him with regards to the stock market (aside from watching this show beside him) was him coming home during the Tech Bubble — which I did not know it as such at the time, nor did he — and saying things like, “Wow, I can’t believe it, my AOL stock doubled again today” as he set his briefcase down and went to change for dinner. He did not work to understand what was going on with the companies he owned and he did not encourage me to be curious about it.

In high school I never took one of those “business” classes where everyone plays the “stock market game” and creates a fantasy portfolio. In retrospect, this is a terrible way to introduce young people to the idea of common stock investing as most learn from it what I learned– it’s “fun”, it’s “random” (the winner was inevitably some kid who got lucky betting on things that happened to go up during the course of the game) and there are no costs if you’re wrong because everyone was playing with funny money. But I remember being disappointed I didn’t get to play, and excited when I realized I could find the website on my own and play on my own time, although I quickly gave up when I realized I had no idea how to pick a stock and was basically just rolling dice.

When I began working over the summers in between school years and accumulating some savings I began looking for yield beyond my bank account. This was during a time where a “safe” money market fund was yielding just over 5% a year. I put my savings with Vanguard’s MMF and felt quite wealthy watching it grow at 5%, not knowing what a money market fund was or why it offered more than a bank account and not knowing that with a little elbow grease I could earn much more than that as a proper stock investor.

Fast forward to sometime in college and I was much more interested in this idea of investing as a discipline. I was becoming aware of the world of finance, likely in part due to my proximity to the global center of it (“Wall Street”), in part because many classmates and friends were talking about it as a career opportunity and in part because my readings and interests and slowly taken me there. I became aware of the hedge fund industry and the idea that people made their living making investments all day long. I decided that sounded pretty interesting to me (much more on this topic in a future post I plan to write) and might be something I’d like to pursue as well.

And somewhere in there I came across a recommendation to read The Intelligent Investor by Benjamin Graham. Which I proceeded to do, but, despite reading the book from cover-to-cover, including the end chapter commentary by Jason Zweig that many people detest but which I think actually adds some value and can even be enjoyed as a standalone reading, I really did not understand much of what I read. And the even greater sin was that I failed to apply what little I understood.

I did not begin searching for Ben Graham stocks. I did not use his principles of risk management in constructing my own portfolio. I did not look for opportunities to spite Mr. Market and buy stocks when he was panicking and sell them when he was giddy. I did not begin looking at stocks as ownership certificates in real businesses. I did not even do any investing beyond my Vanguard MMF! For whatever reason at this stage in my life investing was a purely academic interest.

This began to change as I neared the end of college and was seriously considering a career in finance. Around this same time, I had been reading deeply of Austrian economics and had become convinced, like many who had, that we were on the precipice of a global economic calamity that would start with the housing sector and quickly come to overwhelm the banking sector. I was obsessed with this End Times prognostication and spent most of my time working to understand what was coming and thinking about an investment strategy that would stand to benefit from macro disruption. I was finally ready to take some action and I ended up doing two things.

The first thing I did was to sow doubt about my parents’ equity holdings in their mind, particularly their heavy concentration in the financial sector (prime offender: Citibank), which their broker was convinced was one of the cheapest parts of the market and thus he had increased the total exposure in their blue chip portfolio. I told them the end was coming and they should liquidate everything and go to cash. I was initially unsuccessful, but when the first hiccup in the markets occurred, my dad got worried and decided to at least follow my advice to sell all his financial stocks, including Citibank, his largest position, which the broker bleated about painfully for weeks afterward.

The second thing I did was to follow Peter Schiff’s strategy regarding the Great Decoupling of the United States from the rest of the world, and what better way than to open an account with Schiff’s firm, Europacific Capital, to buy all these great foreign stocks (especially commodity companies and infrastructure businesses) at rich commissions? I put essentially my life savings to date into this account, naively trusted my broker when he told me he’d help keep an eye on the portfolio and recommend trades to me at appropriate times, and chose five companies (“that should be plenty of diversification!”) from a list of about 15 or 20 he pulled for me on a basis that was then entirely arbitrary and is now completely unmemorable for me. All I know is I did not use any of Ben Graham’s principles or ideas and I think I feigned a knowing approach by saying the P/E ratios of the companies I was about to buy out loud, almost like an invocation, but beyond that I had little idea what these companies did, what valuation I was buying them at and how big my Margin of Safety was.

The way the story turned out is my parents were grateful and I was obliterated. I saved my parents a lot of money with the move to liquidate the financial stocks as that blunted most of the pain that was to come. After the markets had tumbled some 20-25% (and maybe about 30-40% of the total move down) they ended up liquidating the rest of the stock portfolio and held on to their high quality bonds, something that I had no opinion on despite reading Ben Graham and being pretty opinionated about most other credits in the market (I could talk your head off about CDOs and what a danger they were long before Michael Lewis wrote any books on the subject) which was a good move as interest rates went ZIRP. They really thought I was a genius and neither of us knew I just happened to be lucky. I should’ve been more clued in by what happened in my own portfolio.

My own portfolio lost a lot. At one point I was down about 70%. America did not decouple from the world and the world did not decouple from America. Everybody rode the coaster down together and because I picked economically sensitive businesses at near peak valuations it was indeed a painful ride. I had no idea what to do other than to just hold on (actually, not a bad response and much better than the typical mistake of panicking and selling to Mr. Market at the worst time). But after about two or three years of waiting after the crisis, my portfolio was still down about 50% and I decided it was time to admit I had screwed up and realize my losses. If I had just been more patient, I might have been down at most 20-25%– a bad drawdown, for sure, but much different in terms of wounded pride and sucked out capital than a 50% permanent impairment; even my crappy picks which had amounted to little more than throwing darts at a stock table would’ve caught a bid like everything else during the Great Global Reflation.

Being massively right in my parents’ case and massively wrong in my own should’ve been a good indication I didn’t know what I was doing. Instead, I took away the lesson that macro investing worked and I might actually be good at it if I could learn how to do it consistently well, and stock picking on the other hand didn’t seem to work because I had picked stocks and that went poorly for me. It was embarrassing, particularly because I had told a lot of people ahead of time what I was doing and why, but I found myself still interested in the subject and wanting to explore it more.

That was hard to do as a career because the aftermath of the global financial crisis made getting a job in the industry almost impossible. I went to work for another large company and made more idiotic macro bets while I bided my time. Somehow I was able to stifle the cognitive dissonance of reading Security Analysis at my desk at work (covered wrapped in a brown paper grocery bag, and only when I had gotten my paid work finished for the day) while buying things like the 3X leveraged short financial ETF in what was left of one of my personal accounts. I have no idea why I was reading Ben Graham’s magnum opus analyst handbook at this time or how I had even heard of it and once again I understood little of what I read despite going cover-to-cover, and applied none of it. I scraped some short-term capital gains on these stupid trades and then gave it all back and then some when my luck ran out. I finally threw in the towel and swore off “investing” for awhile as a personal practice while I continued to be interested in getting into it as a career.

After months of pestering a small global macro fund I had heard about in Texas about an analyst position, they agreed to hire me and suddenly it seemed my dreams were coming true. I was convinced this was just the beginning of a long and successful career as a professional investor and despite my initial failures at investing I was excited to come on board and learn what it was really all about.

It turned out not to be so. I learned little about financial analysis or portfolio management in a positive sense although my time spent with this firm armed me with an abundance of lessons in what not to do. The gentlemen I worked for were extremely intelligent, talented and honest and had made out like bandits during the crisis with their own successful predictions and even more successful operations, but like me they had been fooled by luck and had failed to appreciate that successful investing is a practical exercise, not a moral one. They could not let go of their critical view of economic events and the connection they had to the market and they became as embittered as they were emboldened to soldier on against the forces that be in hopes of teaching the world a lesson in folly.

That they did, but the folly was their own. Sadly, it was my folly, too, because despite seeing that it wasn’t working, I was also rather gung ho about it. I couldn’t figure out HOW to invest like that in my own portfolio, so I was mostly inactive as an investor. I also began work on another project in cognitive dissonance. This time, I had managed to figure out that Ben Graham had a student, Warren Buffett, and that there was all kinds of information out there about Buffett, his life, his investment record and his method for investing and risk management. I began drinking heavily at this fountain while taking another turn at the writings of Ben Graham. I was beginning to wonder if maybe the macro stuff was a dead end and there wasn’t something to this value investing concept. I was thinking about doing it in my own account. My timing was again almost impeccable, but I did not know it!

First though, I decided to pitch my bosses on value investing. Maybe we could balance out some of the short exposure in the portfolio with some of this Ben Graham stuff? There seemed to be a lot of opportunities out there based on some quick screens I ran. That’s when I got the dumpster diving speech.

Value investing is a lot like dumpster diving– every once in awhile you come up with a Picasso, but most of the time you come up smelling like garbage!

And besides, everyone knows Warren Buffett is an asshole and just lucky, he’s been on the side of the establishment which has put the wind in his sails, he got a bailout when his house of cards almost came tumbling down in the crisis and no one has been able to replicate his success, likely because he is working some kind of fraud. You don’t want to go there, kid, and neither will we!

My confidence was completely shot! This turned out to be the second best time to get into value investing besides the March 2009 low itself, but I had just been told this was basically the stupidest idea a person could come up with– and since I hadn’t managed to learn much from them, this was about the only idea I had. I was burned out on them, burned out on my broken dream and burned out on how bad I seemed to be at investing in general. So I called it quits.

I ended up joining the family business while I licked my wounds, egotistical and otherwise. The idea was to have a hideout while I figured out where my next heist would be. I was trying to figure out how to go be an analyst somewhere else but I didn’t know where. It seemed like I needed an education, so I began what I came to call my “Personal MBA” program, an intense, year-long effort of reading everything I could get my hands on about business, finance and investing. I’ve written about that earlier on this blog.

Buffett talks about value investing as something that a person either takes to immediately or rejects outright. While I hadn’t yet successfully employed the concepts in my investment practice, it had clearly infected my mind. The macro thing did not make sense to me at a conceptual level but the idea of studying stocks as businesses and looking for indications of cheapness that lent a margin of safety did. I think this is why I kept pushing on and went through my Personal MBA despite having no track record otherwise.

A few interesting things happened during this time period and shortly thereafter. First, I began doing real research and analysis on individual companies– I built spreadsheets and collected operating data, I read SEC filings and books about industry and company history and began to appreciate what it meant to approach the process of investing like a businessman. Second, I actually made some investments– some net-nets in the US (what remained at this stage in the game), some good companies at great prices and even a wonderful company at an un-fair price and later, a basket of foreign net-nets (my JNet strategy), along with a few special situations and some capital structure arbitrages I was coattailing on with another investor friend. While there were a few flops that either went nowhere or I lost a little on, for the most part my results on an individual investment basis were good to great and a few were even outstanding. Third, I continued believing I had some kind of crystal ball as far as market timing was concerned and I let that dominate my overall investment program– as described at the beginning of this essay, I took small, almost meaningless positions in most of the companies I invested in (aside from the JNet basket) such that when they worked, they didn’t have much of an impact on my portfolio overall and when they failed, they also didn’t have much of an impact. It was an excellent way to have nothing to show for the effort I put into it!

While this exercise helped me to build intellectual confidence, I was still not matching it with practical confidence and I doubted myself a lot along the way. What’s worse, my obligations in the family business continued to compete with my interest and efforts in investment management such that they were not only a serious distraction at times from a more meaningful and concentrated effort in this space but they were also a suitable rationalization for why I couldn’t just go all-in and really commit to my investment activity.

At one point I changed operational roles within our business and finally had no bandwidth to spare for investing. I went functionally inactive on investing for almost two years and decided ahead of time that it would be irresponsible to have the portfolios exposed even the minor amount they were at that point in time (especially because I kept not liking what I was seeing as I gazed into my crystal ball!) while I wasn’t paying any attention to them so I liquidated to concentrate on operational issues full time. Incredible, given that sitting on one’s hands is said to be the hardest part of managing a well-constructed portfolio and I missed out on even more returns, meager as they were, with this decision.

Recently I have returned to a more strategic role in the family business and it is more clear now than ever that we need someone to be working on sound capital allocation for us. The most logical person to do this is me, in part because I was the person to point out the need and in part because I’m the only person with that kind of knowledge base. But do I have the experience?

This is where we come to some of the learnings I have taken away from my journey to date. As I mentioned before, I made some grievous errors early on in my investment career. I violated the first rule of investing countless times and I am lucky to still be standing thanks in large part to my extreme propensity to save which has allowed me to accumulate savings faster than my early rate of depletion. But since that time period, when I have actually applied the value investing framework knowingly and cautiously, my results have been good and within expectation. If I had not been so lacking in confidence and tried to make up for my initial indiscretion by being over-conservative, my investment operations at scale would’ve yielded an agreeable rate of return on the capital employed. Just as I must be honest with myself about my initial mistakes, I must be honest about some of my virtues and I think I can count these decisions as part and parcel.

One standard I tried to live by in my earlier investing was perfection. I often failed to act because I could not be sure of absolutely safety and I had determined that if I ever made another mistake in my investment operations, particularly with regard to the macro environment and crystal-ball gazing, that these mistakes would be unforgivable and would reveal how I was in actuality no better, in a moral sense, than any of the other petty mortals plying this trade.

This is, after much contemplation, an unreasonable standard to try to live up to because it is impossible to act at all under this standard. To be a successful investor, one does not need to be the best– one needs to simply act prudently according to sound methods. But, as my re-reading of Benjamin Graham’s classic text recently helped me to appreciate, one must act. Facing this fact, what can I do? The best I can, is the only answer I’ve found. Given that I know how I made my earlier mistakes, and I believe I understand how I succeeded the few times I did, there is really little risk for me of reprising the role of the vaunted “fuck up artist”.

I’ve also decided to give up my crystal ball and related esoteric knowledge I don’t actually possess. In exchange, I will accept Ben Graham’s portfolio maxim of the 25/75 split, ie, that the maximum exposure to stocks or bonds in one’s portfolio at any one time ought to be no more than 75%, and the minimum exposure ought to be no less than 25%. (And I read “cash and cash-like instruments” as part of the bond allocation, which I think of as “cash yield”.) Having more than 75% exposure suggests a kind of enthusiasm which is, short of a few specific scenarios, likely to involve a speculative-gambling attitude about the future and its risks. And having less than 25% exposure (specifically to stocks) makes it hard to even consider oneself an investor and seems to be evidence of falling prey to crystal ball reading.

This part is really hard right now. “But aren’t we at all time highs for the market?” Yes, we are. It’s very painful to consider that and I feel very nervous about taking the plunge now, so to speak, only to find myself suspended in mid-air as I see the plug being pulled from the pool. I comfort myself a bit by realizing that I am not making a timing “call” in trying to follow this approach, ie, the water is fine, come on in! In fact, I am trying to do the opposite, to resist the temptation of thinking I know and to allow myself an opportunity to take risk, prudently, regardless of what I think of the “market.” The other thing I remind myself is that I will not simply start making investments to achieve some arbitrary portfolio exposure level as quickly as possible. Instead, I now have granted myself “permission” psychologically to invest up to 25% of our capital in appealing opportunities if I should find them. Before, I would’ve had to stop and ask my crystal ball for directions first.

Another thing I’ve learned is that successful investing takes patience no matter what. Even the ideas that worked out well for me on an annualized basis took several years to play out or ripen to their full value. Part of the pressure I used to put on myself in this space was figuring out how I was going to generate X% a year, that year. I didn’t know where to find such an opportunity that was that quick and that safe. It doesn’t exist. Another investment chimera. If I pick safe ideas with a strong upside option and can wait patiently fortune will favor me in time.

There are many people, value investors especially, who have outstanding long term track records who are not Warren Buffett. They are unlikely to be doing something corrupt and they do not have his unique genius. They never seem to have set out for themselves the goal that they must be the best or perfect. They’ve all made mistakes. And they’ve all continued investing in a variety of market conditions, with the wind in their face and the wind at their backs. If they can do it, I can, too.

There are also many obviously lesser people trying their hand at this. They are the gambling fanatics who aren’t even trying to hide it, and the weak minds who have donned the clothing and the diction of the sage investor but do not realize they’re only engaging with the methods at a superficial level. These people are bound for disaster, and yet many of them manage to practice as investors and even confuse other people into letting them run their money. It would be a shame to let the world be dominated by those types and it boggles the mind why they should live with confidence and cheerfully go about their business and I should not.

It has been a long, odd journey to get where I am today. Of course I wish that I had learned these lessons earlier, or in some other way and in so doing to have been spared this trying ordeal to manifest my own confidence. But one of my goals is to learn to live my life without apology or regret and I’ve come to realize that taking the path I took is simply one of the data of my life. I’ve accepted it and I am ready to make good on what I’ve learned by putting the lessons learned to work today, not “when the time is right.” The best time to live life as wisely as one knows how is always today, not tomorrow.

Review – Common Stocks And Uncommon Profits (#investing, #stocks, #growth, #business)

Common Stocks and Uncommon Profits: And other writings by Philip A. Fisher (buy on Amazon.com)

by Philip A. Fisher, published 1996, 2003

Stock market investors who have studied Warren Buffett in detail know that he has cited two “philosophers” of investment theory more than anyone else in being influential in the formation of his own investment approach: Benjamin Graham and Phil Fisher. Graham represents the cautious, conservative, balance sheet-driven Buffett, while Fisher represents the future-oriented, growth-focused, income statement-driven Buffett. If you ask Buffett, while Graham got him started and taught him key lessons in risk management (Margin of Safety and the Mr. Market metaphor), Fisher was the thinker who proved to have the biggest impact in both time and total dollars accumulated. Buffett today, whether by choice or by default due to his massive scale, is primarily a Phil Fisher-style investor.

And yet, in my own investment study and practice, I have dwelled deeply on Graham and did little if anything with Fisher. I tried to read Fisher’s book years ago when I was first starting out and threw my hands up in disgust. It seemed too qualitative, too abstract and frankly for a person of my disposition, too hopeful about the future and the endless parade of growth we’ve witnessed in the markets for several decades since the early 1980s. Surely there would be a time where the Fisher folks would hang their heads in shame and the Grahamites would rise again in the fires of oblivion! After all, “Many shall be restored that are now fallen and many shall fall that are now in honor.”

As my professional career wore on, however, I found there was less and less I could do with Graham and more and more of what Fisher had said that made sense. And if you’re in business, you can’t help but be growth oriented– buying cheap balance sheets isn’t really the way the world works for the private investor. So, I decided it was time to take another look at Fisher’s book and see what I could derive from it as an “older and wiser” fellow. What follows is a review of Part I of the book; I plan to read and review Part II, which is a collection of essays entitled “The Conservative Investor Sleeps Well At Night”, separately.

Keep Your Eye On The Future

One thing I noticed right away is the consistent theme of future-orientation throughout Fisher’s book. Whereas balance sheets and the Graham approach look at what has happened and what is, Fisher is always emphasizing a technique that involves conceptualizing the state of the future. For example, in the Preface he states that one of the most significant influences on his own investment results and those of other successful investors he was aware of was,

the need for patience if big profits are to be made from investment.

“Patience” is a reference to time preference, and time preference implies an ability to envision future states and how they differ from the present and therein see the arbitrage available between the two states. The other key he mentions is being a contrarian in the market place, which sounds a lot to me like the lesson of Mr. Market.

Fisher also says that market timing is not a necessary ingredient for long-term investment success,

These opportunities did not require purchasing on a particular day at the bottom of a great panic. The shares of these companies were available year after year at prices that were to make this kind of profit possible.

While he cites the structural inflationary dynamic of the modern US economy and seems to suggest the federal government’s commitment to responding to business cycle depressions with fiscal stimulus puts some kind of ultimate floor under US public company earnings (unlike in Ben Graham’s time where large companies actually faced the threat of extinction if they were caught overextended in the wrong part of the cycle, Fisher suggests the federal government stands ready to create conditions through which they can extend their debt liabilities and soldier on), he says that the name of the game over the long-term is to find companies with remarkable upside potential which are, regardless of size, managed by a determined group of people who have a unique ability to envision this potential and create and execute a plan for realizing it. In other words, the problem of investing is recognizing strong, determined management teams for what they are, that is, choosing superior business organizations in industries with long runways.

Getting the Goods: The Scuttlebutt Approach

People who know about Fisher typically identify him with the “scuttlebutt approach”. Fisher says scuttlebutt can be generated from:

  • competitors
  • vendors
  • customers
  • research scientists in universities, governments and competitive companies
  • trade association executives
  • former employees (with caveats)

Before one can do the scuttlebutt, however, one has to know where to look. Fisher says that “doing these things [scuttlebutt] takes a great deal of time, as well as skill and alertness […] I strongly doubt that [some easy, quick way] exists.” So, you don’t want to waste your time by going to all the trouble for the wrong idea. He says that 4/5 of his best ideas and 5/6 of the total gains generated over time that he could identify originated as ideas he gleaned from other talented investors first, which he subsequently investigated himself and found they fit the bill. Now, this is not the same thing as saying 4/5 ideas he got from others were worth investing in– the proportion of “good” ideas of the “total” he heard about is probably quite low, but the point again is not quantitative, but qualitative. He’s talking about where to fish for ideas, not how successful this source was.

When I thought about this section, I realized the modern day equivalent was investment bloggers. There are many out there, and while some are utter shit (why does this guy keep kidding himself?) some are quite amazing as thinkers, business analysts and generators of potential ideas. I have too many personal examples of my own here to make mention of them all. But I really liked this idea, cultivating a list of outstanding investment bloggers and using that as your primary jumping off point for finding great companies. The only problem for me in this regard is most of my blogroll are “value guys” that are digging in the trash bins (as my old boss sarcastically put it), whereas to find a Fisher-style company I would need to find a different kind of blogger interested in different kind of companies. But that’s a great to-do item for me to work on in this regard and should prove to be highly educational to boot!

So, assuming you’ve got a top notch idea, what’s next? Fisher is pretty clear here: do not conduct an exhaustive study of the company in question just yet. (In other words, don’t do this just yet, though I loved SoH’s follow-up where he explained what kind of things would get him to do that.) What he does do is worth quoting at length:

glance over the balance sheet to determine the general nature of the capitalization and financial position […] I will read with care those parts covering breakdown of total sales by product lines, competition, degree of officer or other major ownership of common stock […] all earning statement figures throwing light on depreciation, profit margins, extent of research activity, and abnormal or non-recurring costs in prior years’ operations

Then, if you like what you see, conduct your scuttlebutt, because,

only by having what “scuttlebutt” can give you before you approach management, can you know what you should attempt to learn when you visit a company […] never visit the management of a company [you are] considering for investment until [you have] first gathered together at least 50 per cent of all knowledge [you] would need to make the investment

This is the part that really gives a lot of investors pause about Phil Fisher’s approach, including me. Can you really do scuttlebutt, as he envisions it, in the modern era? Can the average investor get the ear of management? Does any of this stuff still apply?

First, some skepticism. Buffett’s biographer Alice Schroeder has said in interviews that much of what made Buffett successful early on in his career is now illegal and would amount to insider trading. The famous conversation with the GEICO chief is one of many that come to mind. This was classic scuttlebutt, and it worked amazingly well for Buffett. And even if it wasn’t illegal, most individual investors are so insignificant to a company’s capital base that they can’t expect nor will they ever receive the ear of management (unless they specialize in microcap companies, but even then management may be disinterested in them, even with significant stakes in their company!) And, assuming they DO somehow get management’s ear, they aren’t liable to learn much of value or interest specifically because most managements today are not only intellectually and politically sophisticated, but legally sophisticated and they are well aware that if they say anything more general than “We feel positive about our company” they’re liable to exposure under Reg FD. This seems like a dead end.

But let me try to tease the idea out a little more optimistically. Managements do provide guidance and color commentary on quarterly earnings calls, and if you are already dealing with a trustworthy, capable management (according to the 15 points outlined below), then there is opportunity to read between the lines here, even while acknowledging that there are many other people doing the same with this info. And people who do get managements’ ear are professional analysts employed by major banks. Again, lots of people read these reports, but there is some info here and it adds color and sometimes offers some “between the lines” information some might miss. And while the information you can get from any one company may be limited, by performing this analysis on several related companies you might be able to fill in some gaps here and there to the point that you can get a pretty fair picture of how the target company stacks up in various ways.

I hesitate a little, but I think the approach can be simulated to a fair degree even today. It’s still hard work. It can’t be done completely, or perhaps as Fisher imagined it. But I think it can be done. And it still comes down to the fact that, even with all this info that is out there, few will actually get this up close and personal with it. So, call it an elbow-grease edge.

After all,

Is it either logical or reasonable that anyone could do this with an effort no harder than reading a few simply worded brokers’ free circulars in the comfort of an armchair one evening a week? […] great effort combined with ability and enriched by both judgment and vision [are the keys to unlocking these great investing opportunities] they cannot be found without hard work and they cannot be found every day.

The Fisher 15

Fisher also is known for his famous 15 item investment checklist, a checklist which at heart searches for the competitive advantage of the business in question as rooted in the capability of its management team to recognize markets, develop products and plans for exploiting them, execute a sales assault and finally keep everything bundled together along the way while being honest business partners to the minority investors in the company. Here was Fisher’s 15 point checklist for identifying companies that were highly likely to experience massive growth over decades:

  1. Does the company have sufficient market scale to grow sales for years?
  2. Is management determined to expand the market by developing new products and services to continue increasing sales?
  3. How effective is the firm’s R&D spending relative to its size?
  4. Is the sales organization above-average?
  5. Does the company have a strong profit margin?
  6. What is being done to maintain or improve margins? (special emphasis on probable future margins)
  7. What is the company’s relationship with employees?
  8. What is the company’s relationship with its executives?
  9. Is the management team experienced and talented?
  10. How strong is the company’s cost and accounting controls? (assume they’re okay unless you find evidence they are not)
  11. Are there industry specific indications that point to a competitive advantage?
  12. Is the company focused on short or long-term profits?
  13. Can the company grow with its own capital or will it have to continually increase leverage or dilute shareholders to do it?
  14. Does the management share info even when business is going poorly?
  15. Is the integrity of the management beyond reproach? (never seriously consider an investment where this is in question)

What I found interesting about these questions is they’re not just good as an investment checklist, but as an operational checklist for a corporate manager. If you can run down this list and find things to work on, you probably have defined your best business opportunities right there.

In the chapter “What to Buy: Applying This to Your Own Needs”, Fisher attempts to philosophically explore the value of the growth company approach. First, he tries to dispel the myth that this approach is only going to serve

an introverted, bookish individual with an accounting-type mind. This scholastic-like investment expert would sit all day in undisturbed isolation poring over vast quantities of balance sheets, corporate earning statements and trade statistics.

Now, this is ironic because this is actually exactly how Buffett is described, and describes himself. But Fisher insists it is not true because the person who is good at spotting growth stocks is not quantitatively-minded but qualitatively-minded; the quantitative person often walks into value traps which look good statistically but have a glaring flaw in the model, whereas it is the qualitative person who has enough creative thinking power to see the brilliant future for the company in question that will exist but does not quite yet, a future which they are able to see by assembling the known qualitative facts into a decisive narrative of unimpeded growth.

Once a person can spot growth opportunities, they quantitatively have to believe in the strategy because

the reason why growth stocks do so much better is that they seem to show gains in value in the hundreds of percent each decade. In contrast, it is an unusual bargain that is as much as 50 per cent undervalued. The cumulative effect of this simple arithmetic should be obvious.

And indeed, it is. While great growth stocks might be a rarer find, they return a lot more and over a longer period of time. To show equivalent returns, one would have to turnover many multiples of incredibly cheap bargain stocks. So this is the philosophical dilemma– fewer quality companies, fewer decisions, and less room for error in your decisions with greater return potential over time, or many bargains, many decisions, many opportunities to make mistakes but also less chance that any one is critical, with the concomitant result that your upside is limited so you must keep churning your portfolio to generate great long-term results.

Rather than being bookish and mathematically inclined (today we have spreadsheets for that stuff anyway), Fisher says that

the successful investor is usually an individual who is inherently interested in business problems. This results in his discussing such matters in a way that will arouse the interest of those from whom he is seeking data.

And this still jives with Buffett– it’s hard to imagine him boring his conversation partner.

Timing Is Everything?

So you’ve got a scoop on a hot stock, you run it through your checklist and you conduct thorough scuttlebutt-driven due diligence on it. When do you buy it, and why?

to produce close to the maximum profit […] some consideration must be given to timing

Oh no! “Timing”. So Fisher turns out to be a macro-driven market timer then, huh? “Blood in the streets”-panic kind of thing, right?

Wrong.

the economics which deal with forecasting business trends may be considered to be about as far along as was the science of chemistry during the days of alchemy in the Middle Ages.

So what kind of timing are we talking about then? To Fisher, the kind of timing that counts is individualistic, idiosyncratic and tied to what is being qualitatively derived from one’s scuttlebutt. Timing one’s purchases is not about market crashes in general, but in corporate missteps in particular. Fisher says:

the company into which the investor should be buying is the company which is doing things under the guidance of exceptionally able management. A few of these things are bound to fail. Others will from time to time produce unexpected troubles before they succeed. The investor should be thoroughly sure in his own mind that these troubles are temporary rather than permanent. Then if these troubles have produced a significant decline in the price of the affected stock and give promise of being solved in a matter of months rather than years, he will probably be on pretty safe ground in considering that this is a time when the stock may be bought.

He continues,

[the common denominator in several outstanding purchasing opportunities was that ] a worthwhile improvement in earnings is coming in the right sort of company, but that this particular increase in earnings has not yet produced an upward move in the price of that company’s shares

I think this example with Bank of America (which I could never replicate because I can’t see myself buying black boxes like this financial monstrosity) at Base Hit Investing is a really good practical example of the kind of individual company pessimism Phil Fisher would say you should try to bank on. (Duh duh chhhhh.)

He talks about macro-driven risk and says it should largely be ignored, with the caveat of the investor already having a substantial part of his total investment invested in years prior to some kind of obvious mania. He emphasizes,

He is making his bet upon something which he knows to be the case [a coming increase in earnings power for a specific company] rather than upon something about which he is largely guessing [the trend of the general economy]

and adds that if he makes a bad bet in terms of macro-dynamics, if he is right about the earnings picture it should give support to the stock price even in that environment.

He concludes,

the business cycle is but one of at least five powerful forces [along with] the trend of interest rates, the over-all government attitude toward investment and private enterprise [quoting this in January, 2017, one must wonder about the impact of Trump in terms of domestic regulation and taxation, and external trade affairs], the long-range trend to more and more inflation and — possibly most powerful of all — new inventions and techniques as they affect old industries.

Set all the crystal ball stuff aside– take meaningful action when you have meaningful information about specific companies.

Managing Risk

Fisher also gives some ideas about how to structure a portfolio of growth stocks to permit adequate diversification in light of the risk of making a mistake in one’s choices (“making at least an occasional investment mistake is inevitable even for the most skilled investor”). His example recommendation is:

  • 5 A-type, established, large, conservative growth companies (20% each) -or-
  • 10 B-type, medium, younger and more aggressive growth companies (10% each) -or-
  • 20 C-type, small, young and extremely aggressive/unproven growth companies (5% each)

But it is not enough to simply have a certain number of different kinds of stocks, which would be a purely quantitative approach along the lines of Ben Graham’s famous dictums about diversification. Instead, Fisher’s approach is again highly qualitative, that is, context dependent– choices you make about balancing your portfolio with one type of stock require complimentary additions of other kinds of stocks that he deems to offset the inherent risks of each. We can see how Buffett was inspired in the construction of his early Buffett Partnership portfolio weightings here.

For example, he suggests that one A-type at 20% might be balanced off with 2 B-type at 10% each, or 6 C-type at 5% each balanced off against 1 A-type and 1 B-type. He extends the qualitative diversification to industry types and product line overlaps– you haven’t achieved diversification with 5 A-types that are all in the chemical industry, nor would you achieve diversification by having some A, B and C-types who happen to have competing product lines in some market or industry. For the purposes of constructing a portfolio, part of your exposure should be considered unitary in that regard. Other important factors include things like the breadth and depth of a company’s management, exposure to cyclical industries, etc. One might also find that one significant A-type holding has such broadly diversified product lines on its own that it represents substantially greater diversification than the 20% portfolio weighting it might represent on paper. (With regards to indexation as a strategy, this is why many critics say buying the S&P 500 is enough without buying “international stock indexes” as well, because a large portion of S&P 500 earnings is derived from international operations.)

While he promotes a modicum of diversification, “concentration” is clearly the watchword Fisher leans toward:

the disadvantage of having eggs in so many baskets [is] that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put into them […] own not the most, but the best […] a little bit of a great many can never be more than a poor substitute for a few of the outstanding.

Tortured egg basket metaphors aside (why on earth do people care what their egg baskets look like?!), Fisher is saying that the first mistake one can make is to spread your bets so thin that they don’t matter and you can’t efficiently manage them even if they did.

Aside from portfolio construction, another source of risk is the commission of errors of judgment.

when a mistake has been made in the original purchase and it becomes increasingly clear that the factual background of the particular company is, by a significant margin, less favorable than originally believed

one should sell their holdings, lick their wounds and move on. This needs to be done as soon as the error is recognized, no matter what the price may be:

More money has probably been lost by investors holding a stock they really did not want until they could “at least come out even” than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.

Further,

Sales should always be made of the stock of a company which, because of changes resulting from the passage of time, no longer qualifies in regard to the fifteen points… to about the same degree it qualified at the time of purchase […] keep at all times in close contact with the affairs of companies whose shares are held.

One vogue amongst certain investors is to be continually churning the portfolio from old positions to the latest and greatest idea, with the assumption being that time has largely run its course on the earlier idea and the upside-basis of the new idea is so much larger that liquidity should be generated to get into the new one. Fisher advises only using new capital to pursue new ideas rather than giving in to this vanity because,

once a stock has been properly selected and has borne the test of time, it is only occasionally that there is any reason for selling it at all

The concept of “investment” implies committing one’s resources for long periods of time. You can’t emulate this kind of trading activity in the private market, which is a very strong indication that you should try to avoid this behavior in public markets. A particularly costly form of this error is introducing macro-market timing into one’s portfolio management, ie, this stock has had a big run up along with the rest of the market, things are getting heady, I will sell and get back in at a lower cost. I’ve done this myself, most recently with Nintendo ($NTDOY) and even earlier with Dreamworks ($DWA). Fisher says it’s a mistake:

postponing an attractive purchase because of fear of what the general market might do will, over the years, prove very costly […] if the growth rate is so good that in another ten years the company might well have quadrupled, is it really of such great concern whether at the moment the stock might or might not be 35 per cent overpriced? That which really matters is not to disturb a position that is going to be worth a great deal more later.

It plays to a logical fallacy that a company that has run up has “expended” its price momentum, while a company that has not had a run-up has something “due” to it. On the contrary, Fisher points out that many times the material facts about a company’s future earnings prospects change significantly over time from the original purchase, often to the good, such that even with a big run-up, even more is in the offing because the future is even brighter than before– remember, always keep an eye on the future, not the present or the past!

And similarly, if one has an extremely cheap cost basis in a company, one has an enormous margin of safety that should give further heed to trying to jump in and out of the stock when it is deemed to be overvalued.

He adds that, like wines, well-selected portfolio holdings get better with age because,

an alert investor who has held a good stock for some time usually gets to know its less desirable as well as more desirable characteristics

and through this process comes to develop even more confidence in his holdings.

If you’ve read some of my thinking about the philosophy of building multi-generational wealth through a family business, you’ll see once again the direct parallel to private market investing in Fisher’s conclusion:

If the job has been correctly done when a common stock is purchased, the time to sell it is– almost never.

Conclusion

Distilling Part I down to its essence, I concluded that the most important skill for generating long-term gains from one’s investing is still about having a disciplined and consistent investment program followed without interruption and in the face of constantly nagging self-doubt (“In the stock market a good nervous system is even more important than a good head.”) The particular program that Fisher recommends be followed is to:

  1. Create a network of intelligent investors (bloggers) from which to source ideas
  2. Develop a strong scuttlebutt skill/network to develop superior investment background
  3. Check with management to confirm remaining questions generated from the 15 step list
  4. With the conviction to buy, persevere in holding over a long period of time

If you can’t do this, you probably shouldn’t bother with the Fisher approach. Whether it can be done at all is an entirely separate matter.

4/5

Review – Losing My Virginity (@richardbranson, #entrepreneurship, #books, #review)

Losing My Virginity: How I Survived, Had Fun and Made a Fortune Doing Business My Way

by Richard Branson, published 2011

 

Spoiler alert– this book is choppy and inconsistent in the pacing and entertainment factor of its narrative. You really need to read between the lines a bit to get the most value out of it. That being said, it’s surprisingly literary for a dyslexic former publisher of a student magazine and I found Branson’s repeated reference to his high-altitude balloon voyage trials to be an outstanding metaphor for his life as a businessman and entrepreneur.

You see, in Branson’s ballon journeys, the key factors of any consistency were that: a.) Branson was knowingly and openly taking what he perceived to be a potentially life-threatening risk b.) Branson was almost always underprepared for it, or decided to go ahead with his attempt despite early warnings that something was amiss and c.) nonetheless, he somehow managed to survive one disaster after another, only to try something bigger and bolder the next time around.

And this is quite similar to the way he comported himself as an entrepreneur on so many occasions. Again and again, he’d make a daring foray into a business, market or industry he didn’t quite understand, the company would stumble after an early success leaving them all on the brink of failure and yet, each time they’d double down and somehow win.

In that sense, Branson is a perfect example of survivorship bias. On the other hand, having so many narrow misses that turn into massive accelerators of a person’s fortune start to make you wonder if isn’t mostly luck but rather mostly skill.

As an entrepreneurial profile, “Losing My Viriginity” is full of all kinds of great successes and astounding failures. With regards to the failures, something I found of particular interest was the fact that Branson’s company were victims of some of the most common pitfalls of other businesses throughout its early history: taken for a ride by indomitable Japanese owners/partnerships in the 80s, repeated victim of the LBO-boom and the private/public buyout-cycle in the 80s and 90s. When you read these stories in the financial press it always seems to happen to the rubes of the business world, but Branson’s foibles help one to realize even rather sophisticated types can get taken in now and then.

The volatility in Branson’s fortunes do leave one with a major question though, namely, why did Branson’s company ultimately survive?

This isn’t a Harvard Business School case study so I don’t mean to pass this off as a qualified, intelligent answer to that question, but I will attempt a few observations and, in typical HBS fashion, some or all of them may be contradictory of one another and none will be provided with the precise proportional contribution they made to the end result:

  • the group had a cultural commitment to change and dynamism; they were not so much their businesses, but a culture and group of people who did business a particular way, a true brand-over-merchandise, which allowed them to reinvent themselves numerous times
  • the group strategically focused on being the low-cost provider in their industry, usually while simultaneously attempting to pursue the seemingly mutually exclusive goal as being seen as the highest quality offering as well
  • the group focused on serving customers but equally saw treating its employees with concern as an important value
  • the group consciously created a brand that could be applied to diverse businesses (see point #1)
  • the group pursued businesses that seemed “interesting” or sensually appealing to it, which ensured that everyone involved was motivated to do well because they liked the work they had chosen

Another thing I noticed about Branson and the development of his company was the attention he paid to the composition of management and owners and his dedication to weeding out those who were not good fits in a charitable way. Channeling the “best owner” principle, Branson made a conscious effort to buy out early partners whose vision and tastes did not match the current or future vision of the group. In this way, the company maintained top-level focus and concentration on a shared strategic vision at all times, sparing itself the expense and distraction of infighting and wrangling over where to go next and why.

Another aspect of the company’s resilience had to do with its operational structure. Branson built a decentralized company whose debts and obligations were kept separate. In an environment where new ventures were constantly subject to total failure, this arrangement ensured that no one business failure would bring the entire group down.

The final lessons of the Branson bio were most instructive and had to do with the nature and value of forecasting.

The first lesson in forecasting has to do with the forecasts others make of us, or the world around us. For example, Richard Branson had no formal business training, he grew up with learning disabilities (dyslexia) and he was told very early on in his life by teachers and other adult and authority figures in his life that he’d amount to nothing and his juvenile delinquency would land him in prison. Somehow this worthless person contributed a great deal to society, through business and charity, and by most reasonable measures could be considered a success, making this forecast a failure. If one had taken a snapshot of the great Warren Buffett at a particular time in his adolescence, when the young boy was known to often take a “five-finger discount” from local department stores, it might have been easy to come up with a similar forecast about him.

I’m not sure how to succinctly sum up the concept there other than to say, “Things change.” Most forecasts that involve extrapolating the current trend unendingly out into the future will probably fail for this reason.

The second lesson in forecasting has to do with how we might attempt to forecast and plan our own lives. When we have 50, 60, 70 or more years of a person’s life to reflect on, it is easy to employ the hindsight bias and see how all the facts of a person’s life were connected and led them inexorably to the success (or infamy) they ultimately achieved. And certainly there are some people, again using Buffett as an example, who from an early age were driven to become a certain something or someone and so their ability to “predict their future selves” seemed quite strong.

But the reality is that for the great many of us, the well-known and the common alike, we really don’t have much of a clue of who we are and what we’ll ultimately become. The future is uncertain and, after all, that’s the great puzzle of life that we all spend our lives trying to unravel. Richard Branson was no different. He was not born a billionaire, in a financial, intellectual, personal or other sense. He had to learn how to be a businessman and how to create a billion dollar organization from scratch. Most of the time, he didn’t even know he was doing it. In other words, HE DID NOT KNOW AHEAD OF TIME that he would become fabulously wealthy, and while he was hard-working and driven, it doesn’t even appear he purposefully intended to become so.

Maybe we should all take a page from Branson’s book and spend less time trying to figure out what’s going to happen and more time just… happening. We could sit around all day trying to figure life out, or we could follow the Branson philosophy where he says, “As for me, I just pick up the phone and get on with it.”

3/5

Video – Rahul Saraogi On Value Investing In India (#valueinvesting, #India, @manualofideas, #investing)

The Manual of Ideas presents Rahul Saraogi, managing director of Atyant Capital Advisors

Major take-aways from the interview:

  • Referring to Klarman, finding ideas and doing the analysis is a small part of investing; the two most critical factors to succes in any investment as a minority shareholder are corporate governance and capital allocation
  • Good corporate governance means a dominant shareholder who treats minority shareholders like an equal business partner: even aside from egregious fraud and legal violations, you can face situations where dominant shareholders use the company like a piggy bank or to promote personal agendas
  • Once you’ve cleared the corporate governance hurdle you must consider capital allocation: many times companies follow the same strategy that got them from 0 to a few hundred million in market cap, which will not work to get them to the next level; often by this time the dominant shareholder is sufficiently wealthy and loses interest in capital allocation to the detriment of minority shareholders
  • India’s investment universe:
    • Indian GDP close to $2T
    • Indian market cap $1.5-2T
    • 80-85% of India’s market cap is represented by the top 150 firms: mega-cap banks, steel producers, etc., that trade on ADRs and everyone knows of outside of India
    • Thousands of listed companies below this with market caps ranging from $2-3B to a couple million dollars
    • Rahul finds the next 1200-1300 companies below the top 150, with market caps ranging from $50M-$2B, to be the most interesting opportunity
  • Corporate governance is binary: either a company gets it, or it doesn’t
  • Case study: 1998, invested in a sugar manufacturer trading for $20M generating $20M in annual earnings with a 14% tax free dividend yield, virtually debt free, strong moats, dominant player in its field, grew from $20M to $900M market cap, the owners were very focused on growing capital, no grandiose desire to build empires, not trying to grow the top line at all costs or gain rankings, just allocating capital wisely
  • Every investor is looking for shortcuts and binary decisions, ie, “Should I invest in India or not invest in India?”; the reality is it’s a lot of work, it’s about turning over as many stones as you can– what Buffett has done well is finding people who can compound capital and then staying with them through market cycles
  • You can do what Buffett did in any market but you must dive into it, get your hands dirty, do the work it takes and then maintain the discipline to stick with what you’ve found
  • Home-market bias: most people are going to allocate most of their capital in their home-market, because by definition anything that is not familiar or proximate is considered risky; consequentially, “locals” will disproportionately benefit from economic and financial gains in their local markets
  • India can not and likely will not become a dominant allocation in a foreign investors portfolio; without devoting 100% of your time and energy to understanding that market, or having someone invest on your behalf who does, you will likely not understand the culture, motivation and habits of the people in that market
  • “It is imperative that in any market you go with people who understand it and are focused on it full time because investing is ultimately bottom-up”
  • Accounting, financial reporting and investor relations practices are modeled off the US and UK so they’re similar; however, many businesses are run by one or two entrepreneurs and they’re often too busy to be available to speak with outside investors, but persistence pays off when they realize you’re interested in learning about their business
  • Access to capital in Indian markets has improved, meaning it has become easier for Indian companies to scale
  • Why does India have high rates of capital compounding? India is a 5,000 year old civilization and has had borrowing, lending and private markets for capital that entire time meaning people are aware of capital compounding; that being said, India has companies and management that understand ROC, those that don’t, and those that are essentially professional Ponzi-schemes, issuing capital at every market peak and then trading for less than the issued capital at the trough because they’re constantly destroying wealth
  • Rahul sees the government as incapable of providing the public infrastructure needed by the growing economy; he sees the economy turning toward a “private-public partnership” model that is more private than public– enlightened fascism?
  • As companies rushed into this private-public space, a lot of conglomeration and corporate mission-creep occurred, resulting in systemically low ROC for companies in the infrastructure space as most as poorly run; failure of top-down investing thesis
  • “I’m looking for confirmation in facts, not in other investors’ opinions”
  • I can comment on whether valuations for individual companies make sense, but I can’t make a judgment on the value of a broad market index, I just don’t think that number means anything
  • Risk management: develop assumptions about the company’s business and then periodically analyze what the company is doing relative to original investment hypothesis; if your assumptions prove to be wrong or something changes drastically with the company, that is when you hit a “fundamental stop-loss” and corrective action needs to be taken immediately, even if the stock has done well and the price has risen

Video – Toby Carlisle, Q&A Notes at UC Davis Talk on Quantitative Value (@greenbackd, #QuantitativeValue)

Click here to watch the video (wear earphones and bring a magnifying glass)

UC Davis/Farnam Street Investments presents Toby Carlisle, founder and managing partner of Eyquem Investment Management and author of Quantitative Value, with Wes Gray

Normally I’d embed a video but I can’t seem to do that with the UC Davis feed. Also, these are PARAPHRASED notes to the Q&A portion of Toby’s talk only. I ignored the “lecture” portion which preceeded because I already think I get the gist of it from the book. I was mostly interested in covering his responses to the Q&A section.

The video is extremely poor quality, which is a shame because this is a great talk on a not-so-widely publicized idea. I wish there was a copy on YouTube with better audio and zoom, but no one put such a thing up, if it exists. I hope Toby does more interviews and talks in the future… hell, I’d help him put something together if it resulted in a better recording!

I had trouble hearing it and only thought to plug in some earbuds near the end. Prior to that I was contending with airplanes going overhead, refrigerator suddenly cycling into a loud cooling mode as well as my laptop’s maxed out tinny speakers contending with the cooling fans which randomly decided to cycle on and off at often the most critical moments. I often didn’t catch the question being asked, even when it wasn’t muffled, and chose to just focus on Toby’s response, assuming that the question would be obvious from that. That being said, I often conjoined questions and responses when there was overlap or similarity, or when it was easier for me to edit. This is NOT a verbatim transcript.

Finally, Toby recently created a beta forum for his book/website, at the Greenbackd Forum and I realize now in reviewing this talk that a lot of the questions I asked there, were covered here in my notes. I think he’s probably already given up on it, likely due to blockheads like me showing up and spamming him with simpleton questions he’s answered a million times for the Rubed Masses.

Major take-aways from the interview:

Q: Could we be in a “New Era” where the current market level is the “New Mean” and therefore there is nothing to revert to?

A: Well that’s really like saying stocks will revert down, not up. But how could you know? You could only look at historical data and go off of that, we have no way to predict ahead of time whether this “New Mean” is the case. I think this is why value investing continues to work, because at every juncture, people choose to believe that the old rules don’t apply. But the better bet has been that the world changes but the old rules continue to apply.

Q: So because the world is unknowable, do you compensate by fishing in the deep value ponds?

A: I like investing in really cheap stocks because when you get surprises, they’re good surprises. I find Buffett stocks terrifying because they have a big growth component in the valuation and any misstep and they get cut to pieces; whereas these cheap stocks are moribund for the most part so if you buy them and something good happens, they go up a lot.

Q: (muffled)

A: If you look at large cap stocks, the value effect is not as prevalent and the value premia is smaller. That’s because they’re a lot more efficient. There’s still only about 5% of AUM invested in value. But the big value guys portfolios look very similar; the value you have as a small investor is you don’t have to hold those stocks. So you can buy the smaller stuff where the value premia is larger. The institutional imperative is also very real. The idea of I’d like to buy 20 stocks, but I have to hold 45. That pushes you away from the optimal holdings for outperformance.

Q: (muffled)

A: The easiest way to stand out is to not run a lot of money. But no one wants to do that, everyone wants to run a lot of money.

Q: (muffled)

A: The model I follow is a bit more complicated than the Magic Formula. But there are two broad differences. I only buy value stocks, I only buy the cheapest decile and I don’t go outside of it, and then I buy quality within that decile. ROIC will work as a quality metric but only within the cheapest decile. ROIC is something Buffett talks about from a marketing perspective but I think in terms of raw performance it doesn’t make much sense. There’s definitely some persistence in ROIC, companies that have generated high returns on invested capital over long periods of time, tend to continue to do that.  If you have Warren Buffett’s genius and can avoid stepping on landmines, that can work. But if you don’t, you need to come up with another strategy.

Q: (muffled)

A: Intuition is important and it’s important when you’re deciding which strategy to use, but it’s not important when you’re selecting individual stocks. We can be overconfident in our assessment of a stock. I wonder whether all the information investors gather adds to their accuracy or to their confidence about their accuracy.

Q: (muffled)

A: All strategies have those periods when they don’t work. If you imagined you ran 4 different strategies in your portfolio, one is MF, one is cheap stocks, one of them is Buffett growth and one is special situations, and you just put a fixed amount of capital into each one [fixed proportion?] so that when one is performing well, you take the [excess?] capital out of it and put it into the one that is performing poorly, then you always have this natural rebalancing and it works the same way as equal-weighted stocks. And I think it’d lead to outperformance. It makes sense to have different strategies in the fund.

Q: (muffled)

A: QV says you are better off following an indexing strategy, but which market you index to is important. The S&P500 is one index you can follow, and there are simple steps you can follow to randomize the errors and outperform. But if you’re going to take those simple steps why not follow them to their logical conclusion and use value investing, which will allow you to outperform over a long period of time.

Q: (muffled)

A: Not everyone can beat the market. Mutual funds/big investors ARE the market, so their returns will be the market minus their fees. Value guys are 5% of AUM, can 5% outperform? Probably, by employing unusual strategies. Wes Gray has this thought experiment where he says if we return 20% a year, how long before we own the entire market? And it’s not that long. So there are constraints and all the big value investors find that once they get out there they all have the same portfolios so their outperformance isn’t so great. There’s a natural cap on value and it probably gets exceeded right before a bust. After a bust is then fertile ground for investment and that’s why you see all the good returns come right after the bust and then it trickles up for a period of time before there’s another collapse.

Q: (muffled)

A: I think the market is not going to generate great returns in the US, and I am not sure how value will do within that. That’s why my strategy is global. There are cheaper markets in other parts of the world. The US is actually one of the most expensive markets. The cheapest market in the developed world is Greece.

Q: Did you guys ever try to add a timing component to the formula? That might help you decide how to weight cash?

A: Yes, it doesn’t work. Well, we couldn’t get it to work. However, if you look at the yield, the yield of the strategy is always really fat, especially compared to the other instruments you could invest the cash in, so logically, you’d want to capture that yield and be fully invested. I think you should be close to fully invested.

Q: What about position sizing?

A: I equal weight. An argument can be made for sizing your cheaper positions bigger. I run 50 positions in the portfolio. In the backtest I found that was the best risk-adjusted risk-reward. That’s using Sortino and Sharpe ratios, which I don’t really believe in, but what else are you going to use? If you sized to 10 positions, you get better performance but it’s not better risk-adjusted performance. If you sized to 20 positions, you get slightly worse performance but better risk-adjusted performance. So you could make an argument for making a portfolio where your 5 best ideas were slightly bigger than your next 10 best, and so on, but I think it’s a nightmare for rebalancing. The stocks I look at act a little bit like options. They’re dead money until something happens and then they pop; so I want as much exposure to those as I can. I invest globally so the accounting regimes locally are a nightmare. IFRS, GAAP to me is foreign. You have to adjust the inputs to your screen for each country as a result of different accounting standards.

Q: digression

A: Japan is an interesting market. Everyone looks at Japan and sees the slump and says it’s terrifying investing in Japan but if you look at value in Japan, value has been performing really well for a really long time. So, if the US is in this position where it’s got a lot of govt debt and it’s going to follow a similar trajectory, you could look at Japan as a proxy and feel pretty good about value.

Q: (muffled)

A: I’ll take hot money, I am not in a position to turn down anyone right now. It’s a hard strategy [QV] to sell.

Q: (muffled)

A: Special situation investing is often a situation where you can’t find it in a screen, something is being spun out, you have to read a 10-K or 10-Q and understand what’s going to happen and then take a position that you wouldn’t be able to figure out from following a simple price ratio. It’s a good place to start out because it’s something you can understand and you can get an advantage by doing more work than everyone else. It’s not really correlated to the market. I don’t know whether it outperforms over a full cycle, but people don’t care because it performs well in a bad market like this.

Q: What kind of data do you use for your backtests?

A: Compustat, CRISP (Center for Research Into Securities Prices), Excel spreadsheets. You need expensive databases that have adjusted for when earnings announcements are made, that include adjustments that are made, that include companies that went bankrupt. Those kinds are expensive. They’re all filled with errors, that’s the toughest thing.

Video – Hugh Hendry Interviewed By Steven Drobny At LSE (#macro)

Hugh Hendry interviewed by Steven Drobny at the London School of Economics, 2010

Major take-aways from the interview:

  • How he got his start: began at an eclectic asset management firm in Edinburgh, which rotated its young associates; began at age 21 in the Japanese stock market the year after it peaked in 1990; the next year rotated to UK large companies; the next year US equities; moved to London in 1998/9 and no one would employ him because he was a jack-of-all-trades, master of none
  • 1929/1930 marked a “revulsion with debt” period, which changed very slowly, ultimately eradicated from society in 1973/74; then the opposite cycle occurred, with society massively leveraging; during this upswing, it has paid to be optimistic and the financial economy has become the economy; we appear to be on the verge of a generational shift again, where farmers will reign over hedge fund managers
  • Macro opportunities are created by the interactions of economics and the abilities of politicians to try to fudge them
  • “The best trade is the one where you don’t fear the consequences of being wrong”
  • China
    • China’s economic development strategy is not unique, it’s just large-scale; economy is being directed toward sovereign-profit, not corporate-profit
    • Pursuing sovereign power over economic power results in building your economy on foundations of sand; Japan tried the same thing and it appeared to work until it was revealed to have not worked; Confucius saying, “Wise-man not invest in over-capacity”
    • China is like the sun, you can’t get too close or you’ll melt (can’t short equities in China, HK, or commodity futures or equity derivatives in the West); used the “satellite”, bought CDS on a basket of Japanese industries, as Japan is very reliant on trade with China– steel, for example
  • If we’re going to have hyperinflation and the dollar loses its value, you need something profoundly negative to shake the course of economic growth globally, because only if that happens will the central bankers respond with this dramatic decision of hyperinflation
  • Slowdown in China, economic restructuring in Europe would be the economic equivalent of a meteor hitting Earth
  • Market call: the Yen and the USD could appreciate greatly, because there is so much borrowing in those currencies, if asset values take a hit, you have a shortage of dollars or Yen to pay against the collateral values of that lending; combined with calls on the Nikkei at 40,000, 50,000 (want to be very long equities at that point)
  • Good hedge fund managers give great weight to the consequence of their actions and are fearful of them, so they won’t be hurt too much if they’re wrong
  • Being plasticine: we spend so much time trying to see the future, we’re deluding ourselves because we have no chance to see the future; better to be careful and flexible, avoid dramatic injury and maintain optionality to respond to whatever the future holds
  • Be a centipede, not a mountain climber; have a hundred legs so you can let one or two go if you have to do so
  • Strategically, it’s not rational to try to outsmart bright people; bright people are encouraged to be logical in their constructions; my business franchise is trying to get opportunities from the arcane world of paradox, disciplined curiosity, the toolset of the maverick