Investing Thoughts

I stumbled across this just now – I wrote it over a year ago but its certainly not out of date. I wouldn’t say its timeless as investing constantly changes but i wouldn’t see the need to change much. I know an awful lot more about risk management now in my current role as a partner in RiskSystem (www.risksystem.com):

 

My personal views on investing:

MARKETS:

• Diversification is about the best free lunch there is
• Value has proven to be the best long term risk adjusted investment strategy (though it will at times severely underperform eg TMT/Nasdaq bubble)
• Re the tortoise and the hare I am most definitely a scared tortoise – “get rich slowly”
• A 50% drawdown requires a 100% return to get back to your starting position so avoid large drawdowns at all costs
• Well run hedge funds can add alpha but many do not – FOHFs are even worse (due to fees, and inability to invest in the best managers). Some strategies offer genuine uncorrelated returns and will work when you need them eg CTA’s in 2008
• Volatility is not the same as Risk. Risk is not the same as uncertainty. Risk can be quantified e.g. roll of a dice, uncertainty cannot eg S&P at tomorrow’s close. But risk and uncertainty can lead to permanent loss/impairment of capital if not managed
• Equities beat bonds over the long term, but not always. Cash can be king, occasionally. It’s an option – to buy at distressed prices when all are selling
• Equities and GDP growth are not well correlated
• Earnings will match nominal GDP growth over the long term (r=0.93) – eps emanate from revenues
• There are only three sources of returns from the stock market: earnings growth, dividend yield, and the change in P/E
• Figure out the direction of PE’s and you can largely predict equity returns
• Key unknown is inflation – a driver of PE’s. Equities like stable inflation; rising or falling away from stability is not generally good
• Stocks are a long term claim on a stream of income (long duration). Forward earnings models do not have a good long term track record. CAPE and Q-ratio are better Shiller/Hussman/Smithers).
• Profit margins are mean reverting (the average rarely happens!)
• Future US and world GDP likely to be lower going forward – Grantham/Gross/El Erian “new normal” (1-2% pa not 3% long term average)
• There are times to buy and hold (starting PEs low) and times when you need to be active (high PEs, high profit margins)
• For buy and hold periods index funds (passive) are good enough (though tactical overlays can further add value); for active periods use combinations of cash, alternative strategies, active managers, options and more frequent rebalancing
• Beware the folly of forecasting! Analysts are rubbish at it, economists worse. Prepare instead. Analyse don’t forecast. “analysis should be penetrating not prophetic” Ben Graham. Too many “unknown unknowns” – black swans (Taleb)
• Beware “recency bias” and reading only material that confirms your view
• Stability breeds instability – Mises
• Remember what is signal (eg Fed, ECB) and what noise (politicians!) is. Simple is better.
• Investing is simple but not easy.

 

SELECTING FUND MANAGERS:

• Selecting good fund managers is both an art (qualitative – ex ante) and a science (quantitative – ex post). The science bit can be done at computer – the art bit involves interrogating the fund manager – ideally in his/her office
• Quantitative analysis at best gives you 50% of the story – similar to a desk-top valuation on a property (Madoff had a great Sharpe ratio, as would a simple strategy of writing put options, collecting the premia until…)
• Due diligence is an ongoing process – it never ends

Thinks to look for in a good fund manager:

• A process/methodology that can be explained in about two minutes
• Process, Process, Process
• Good process /good outcome = ultimate aim
• Can’t control return, hard to control risk but can control process
• Look for persistence of investment process in different economic/market periods
• Manager must have a good track record over a reasonable period (min three years) using a consistent style/strategy that is his/her own track record – not inherited or spliced together by the marketing guys
• No fund manager outperforms all the time eg Buffet in late 90’,s so don’t expect them to and don’t eliminate the good guys – you won’t if you understand their process
• Process must be scalable
• Process must not simply take advantage of anomalies that could be arbitraged away
• Style drift is a no-no – there are NO exceptions to this
• Manager must be well resourced (in-house or outsourced?)
• The manager’s investment philosophy must make sense e.g. no astrology
• Really good fund managers understand optionality
• Fund managers should have a significant part of their net wealth tied up in the fund
• Separation of custody/valuation/trading. Independent administrator a must – manager must not mark own book under any circumstances. Who are the sub-custodians? Who are the PBs? What banks do they deposit with?
• Operational due diligence is underrated
• Read and understand the constitutional documents of the fund – know the obvious: Gates/swing pricing etc
• Bottom line – this is a people business – the fund managers integrity is key

Simon O ‘Sullivan

December 18^th 2012