When Obnoxious Salespeople Attack

A couple days ago I listened to one of the worst investment pitches I have ever heard. Its manifest awfulness had nothing to do with the investment strategy on offer and everything to do with the presenter.

My colleagues and I endured approximately half an hour of some guy literally shouting at us about how great this fund was and how the fund’s investments have averaged 24% IRRs. The presenter paced like a caged animal for the duration of his monologue, punctuating the pitch with exclamations of “got it, people?!” and “okay, people?!”

I imagine this is kind of what it was like listening to Mussolini speak publicly (if Mussolini had been a real estate guy, anyway). Browbeating prospects into submission was the cornerstone of this guy’s sales process. Not a good look.

Of the myriad varieties of aggressive salespeople, aggressive financial salespeople are probably the most hazardous to your wealth. They are almost always selling you something pro-cyclical and frequently there is financial leverage on top of the cyclicality. (Where do you think the 24% IRRs come from?) This is stuff with significant go-to-zero risk. Caveat emptor.

Nonetheless, I’m fascinated by the psychology of aggressive salespeople. They are okay at making money but in my personal experience at least pretty lousy at hanging on to it. I think that has to do with pro-cyclicality, willingness to take on lots of leverage and a general predisposition toward gambling. These guys live like Thanksgiving turkeys.

turkey_happiness_graph
Source: Attain Capital via ValueWalk

Early in my career I had a number of colleagues who spent time in subprime lending. One of them described how at the peak of the cycle the reps would all be driving sports cars. Then when the cycle rolled over tow trucks would show up to repo the cars as the reps defaulted on their auto loans, same as their customers. You would think people in the subprime lending business would have a better grasp of the credit cycle. But you would be wrong.

To me this is further anecdotal evidence that pro-cyclicality and herd behavior are hard-wired into human nature. But it doesn’t make listening to obnoxious salespeople any easier.

Cause and Effect

This is a quick follow-on from an older post. That post discussed the issue of low interest rates and their impact on justified valuation multiples. I wrote:

A popular contrarian narrative in the markets is that central bankers have artificially suppressed interest rates, and that absent their interventions the “natural” rate of interest would be higher (implying a higher discount rate and thus lower sustainable valuation multiples). The key risk to this thesis is that low rates are not some exogenous happening imposed on the market by a bunch of cognac swilling technocrats, but rather a consequence of secular shifts in the global supply and demand for funds. Specifically, that these days there is a whole boatload of money out there that needs to be invested to fund future liabilities and too few attractive investment opportunities to absorb it all.

If low rates are actually a function of the supply and demand for funds, it doesn’t ultimately matter what central bankers intend do with monetary policy. Market forces will keep rates low and elevated valuations will remain justified.

A friend questioned what I was driving at here, and whether it would be possible to falsify this thesis. For the record, I have no idea whether I’m right or wrong. I’m just trying to envision different possibilities.

That said, I am pretty sure the answer lies in the shape of the yield curve.

As many, many, many commentators have already observed, the Treasury yield curve hasn’t made a parallel shift upward as the Fed raised short-term rates. The short end of the curve has come up pretty significantly but the long end has basically held steady. This is important because central banks tend to have less influence over long-term rates than short-term rates.

chart
Source: Bondsupermart.com

As the Fed continues to shrink its balance sheet, what we would hope to see is the yield curve making a nice, steady, parallel shift upward. What we do not want to see is the 30-year Treasury yield stuck at 3%. The 30-year Treasury yield stuck at 3%, in the absence of Fed intervention, would support the theory that there are structural factors holding down future expected returns. Namely: an excess supply of financial capital relative to opportunities.

My previous posts on this subject have dealt with the risks of naively extrapolating very low interest rates forever. You can attack the issue from different angles but each case more or less boils down to overpaying for risky cash flows.

What I have not done is explored strategies for taking advantage of such an environment. As with the risks, you can attack the issue from a number of different angles. But again, they share a common thread. Here each strategy more or less boils down to taking on duration.

I want to examine this further in a future post, but here is a little teaser…

Duration is most commonly used to analyze interest rate risk in the fixed income world. But the concept can also be applied to other asset classes. Long duration equities are things like venture capital and development stage biotech companies, where cash flows are but a twinkle in your eye when you invest. Long duration equities usually can’t sustain themselves without repeated infusions of investor cash. They thrive when capital is cheap. They die when capital gets expensive.

If you knew capital was going to be remain cheap forever, you would probably want to make long duration equities a significant portion of your portfolio. You could get comfortable investing in really big ideas that would take a long time to be profitable. I am talking about massive, capital intensive projects with the potential to change the world (think SpaceX).

And here’s where I might start getting a little loopy…

…because what if an excess of financial capital is a precondition for tackling the really big projects that will advance us as a species?

Time Horizon Alignment

In a previous post I discussed the idea of time dilation. Time is not absolute. This idea comes to us from physics, which is a fairly exacting and mathematical discipline. The measurement depends on the relative velocity of the observer and whatever it is she is observing. It’s relative. Hence, “relativity.”

Likewise with portfolio management, the velocity of activity in your portfolio will tend to reflect your investing time horizon. Someone managing money trying to think about what a business will look like in a decade may go entire years without placing a single trade. However, this is unlikely to be the case for someone operating on a one to three year time horizon. Especially if that person is managing other people’s money. And doubly so if the other people whose money is being managed are evaluating performance on a quarterly or annual basis.

The tendency among institutional investors these days is to track performance on shorter and shorter intervals. I follow hedge funds that provide weekly performance estimates. This despite offering quarterly liquidity or less! I haven’t the slightest idea what someone is supposed to do with that information. It’s random noise. (Someday I mean to do a piece on the collective delusions of institutional investment committees)

I am convinced the way you should deal with this is to scale your input data to your time horizon. So for example if you are trying to puzzle out what a business might look like in five or ten years you probably should limit your focus to annual reports and proxy statements (at least once your initial due diligence is done). Even quarterly results are likely to introduce a lot of unwelcome noise into the picture.

What if something material changes halfway through the year?

Well, you can still risk manage the portfolio on more frequent intervals (an underlying assumption here is that you are thesis-driven versus trading on technicals). If something nasty, unexpected and material happens to a stock halfway through the year you are going to see it sell off sharply. That’s the trigger to dig in further to see if the investment is impaired. If you own a good business with a strong balance sheet it is going to decline over a period of years, not months. You will have time to get out before things get catastrophically bad.

Now, this only works with high quality businesses. It doesn’t work with classical value investing. It doesn’t work with merger-arb type special situations. It definitely doesn’t work with distressed investing. I watch value investments much more closely. Also cyclicals. Particularly if there is leverage involved. Levered cyclicals (think banks) can deteriorate very rapidly, and fatally.

So it’s not that a long time horizon is always superior.

It’s that mismatches create problems.

Oh, and if anyone happens to know what those weekly performance estimates are good for, drop me a line in the comments.

Who’s Paying For Lunch?

I’ve always been a fan of the old saw, “there are no free lunches.”

Not too long ago I heard this re-framed as “someone has to pay for lunch, and I don’t want it to be me.” I much prefer the second version. It underscores the fact that you can’t destroy risk. You can only lay it off onto someone dumber more willing to bear it than you.

The Wall Street Journal reports on enterprising San Franciscans gaming referral bonuses from VC-backed startups:

Elad Ossadon and Noam Szpiro, who work in software engineering, have become referring pros. In 2016, they created a website called VC Fund My Life, which catalogs discounts and freebies. When a user signs up for the startups listed, they get a referral bonus, often altered by a buzz of their phones.

Mr. Ossadon said before he started the site, he was pushing startups with bonuses on anyone he knew.

“Friends that visit here, move here—friends of friends, random people,” he said. His reward: free burgers and Thai food delivered by startup Postmates and “months over months” of free housecleanings from on-demand services company Handy.

In all, Mr. Ossadon and Mr. Szpiro estimate they have earned over $10,000 in referral credits, although many startups have started to put an expiration on the credits. “The challenge after a while became, can you use your credits before they expire?” said Mr. Szpiro, in a gray knit shirt acquired with the aid of referral credits from online retailer Everlane.

This is one of those “squishy” data points worth paying attention to. Low interest rates encourage investors to move into “long duration” equity investments such as biotech, cryptocurrency and (of course) venture capital. Even with all the talk we hear about “rate jitters” these days, capital remains cheap and cash incinerators are objects of envy.

Guess who’s paying for lunch?

 

Investing vs. “Getting Market Exposure”

Like “financial advisor” and “hedge fund,” the word “investing” is probably one of the most abused terms in our financial lexicon. These days many people use the word “investing” when what they are really talking about is “getting market exposure.”

For fun I googled the definition of investing:

investing_definition
Source: Google

I also re-read this post from Cullen Roche where he discusses “allocating savings” (what I would call “getting market exposure”).

It’s funny how “investors” abuse the term “investing”. What we’re really doing when we buy shares on a secondary exchange is not really “investing” at all. It’s just an allocation of savings. Investing, in a very technical sense, is spending for future production. So, if you build a factory and spend money to do so then you’re investing. But when companies issue shares to raise money they’re simply issuing those shares so they can invest. And once those shares trade on the secondary exchange the company really doesn’t care who buys/sells them because their funds have been raised and they’ve likely already invested in future production. You just allocate your savings by exchanging shares with other people when you buy and sell financial assets.

Now, this might all sound like a bunch of semantics, but it’s really important in my opinion. After all, when you understand the precise definitions of saving and investing you realize that our portfolios actually look more like saving accounts than investment accounts. That is, they’re not really these sexy get rich quick vehicles. Yes, the allure of becoming the next Warren Buffett by trading stocks is powerful. But the reality is that you’re much more likely to get rich by making real investments, ie, spending to improve your future production. Flipping stocks isn’t going to do that for you.

This leads you to realize your portfolio is a place where you are simply trying to grow your savings at a reasonable rate without exposing it to excessive permanent loss risk or excessive purchasing power loss. It’s not a place for gambling or getting rich quick. In fact, it’s much the opposite. It’s a nuanced view, but one I feel is tremendously important to financial success.

I have promised myself I will stop using “investing,” “getting market exposure” and “allocating savings” interchangeably.

For me, the semantic line between investing and “getting market exposure” is a little different from what Cullen proposes. For me it’s this: as an investor you are looking to compound capital at a rate exceeding your cost of capital (opportunity cost), while avoiding permanent impairment of capital.

Yes, “extraordinary” is a fuzzy term. To me, pretty much anything above 10%, net of expenses, is extraordinary. That will give you nearly a 7x return over 20 years. If you can do 15% (an extraordinary achievement, btw), that multiple jumps to over 16x.

Some of you are no doubt thinking you can net 10% annually forever in an S&P 500 index fund. And maybe you are right. In my view the odds are stacked against you over the next 10 years. In fact, I would gladly take the other side of that bet over next 10 years. But beyond the next decade or so it is hard to tell.

The reason is broad market returns measured over long time periods are sensitive to starting valuations. If you ask the average equity analyst he will probably tell you the market is “fairly valued” today based on the one-year forward price/earnings multiple. Which is another way of saying “meh.” By other measures, such as the Shiller CAPE, the US market is extremely expensive. But if you are allocating your savings based on one-year forward earnings multiples you’ve got bigger problems than parsing the nuances of various valuation multiples.

2Q18_JPM_PE_Returns
Source: JP Morgan

Also, analysts kind of suck at forecasting earnings growth. So the forward price/earnings multiple is a flawed input at best.

BI_earnings_forecasts_vs_reality
Source: Business Insider

Anyway, if none of this stuff interests you, you aren’t thinking like an investor. The whole point of investing is to seek out asymmetric risk/reward propositions. That’s very different from “simply trying to grow your savings at a reasonable rate without exposing it to excessive permanent loss risk or excessive purchasing power loss.”

Netflix Levers Up (again)

From Dow Jones Newswires (emphasis mine):

Netflix Inc. (NFLX) said Monday it is planning to tap the high-yield bond market with a $1.5 billion deal. The company said it will use the proceeds for general corporate purposes, including content acquisition, production and development, capex, investments, working capital and potential acquisitions and strategic deals. The company’s most active bonds, the 4.875% notes that mature in April of 2028, last traded at 96.50 cents on the dollar to yield 5.332%, or at a yield spread of 239 basis points over Treasurys, according to trading platform MarketAxess.

I’m not going to belabor the point here. You can decide for yourself whether 5.332% is appropriate compensation for lending on a 10-year term to a company management says will burn $3bn to $4bn of free cash in 2018.

Disclosure: No position.

The Many Flavors Of Dumb

Lack of intelligence (“book smarts”) = “Dumb”

Lack of “street smarts” = “Dumb”

Lack of “emotional intelligence” = “Dumb”

Unwillingness to define a circle of competence = “Dumb”

Inability to define a circle of competence = “Dumb”

Overestimating your own intelligence = “Dumb”

Overestimating the impact of intelligence on outcomes = “Dumb”

Believing intelligence translates into control of outcomes = “Dumb”

There are many dimensions to intelligence. Yet we tend to talk about intelligence in a reductive way. As if it is somehow straightforward to separate the world into the “smart” and the “dumb.” By the standard of raw IQs the folks on Wall Street responsible for creating synthetic CDOs circa 2006 were frighteningly intelligent. Look what they wrought.

People with low IQs tend not create really bad outcomes. At least not at the level of society at large. People with low IQs are rarely put in a position where they have that much power and influence.

Really bad outcomes result from “smart” people overestimating their intelligence. They result from “smart” people mistakenly believing being “smart” allows them to control outcomes in complex systems. And they result from “smart” people being coerced into doing dumb things by warped incentive systems.

Some examples (not comprehensive):

Literally every financial crisis.

The Titanic.

Literally every speculative bubble.

World War I.

The Challenger explosion.

Tobacco companies.

The Hindenburg.

Love Canal.

Badly cooked dinners.