My Definition Of Wealth

I am not motivated by money.

That may sound strange coming from someone who works in investment research, and I certainly don’t mean to imply I don’t care about money at all. I have to make money to live a certain quality of life. Money will also allow me to achieve financial independence some day. So maybe I am motivated by money and I just define wealth differently than others.

For me, wealth is not an extravagant lifestyle, a huge mansion or fancy cars and clothes. Rather, wealth is financial security and independence. Wealth allows you to write and say what you want, when you want, and how you want.  Wealth is “fuck you” money.

While I try not to curse much on this blog (requiring a herculean effort at times), it’s important to me that bit of profanity be written out in full. To sanitize the statement is to diminish its power.

The link is to a post by J.L. Collins:

If memory serves, it comes from James Clavell. In his novel “Tai Pan” (highly recommended BTW) a young woman is on the quest to secure 10 million dollars. She calls it her “F-you money,” although the F-word is spelled out in the book. So you can look it up in case you’re wondering just what word it is. And 10m is far more than it takes, at least for me. More monk than minister.

I may not have known what it was called, but I knew what it was and why it is important. There are many things money can buy, but the most valuable of all is freedom. Freedom to do what you want and work for whom you respect.

Those who live paycheck to paycheck are slaves. Those who carry debt are slaves with even stouter shackles. Don’t think for the moment their masters don’t know it.

Much of what we believe about wealth we accept without critical thought. It does not help that we are inundated with messaging glorifying conspicuous consumption. What was the Fyre Festival but a monument to conspicuous consumption and personal vanity? What does it say about conspicuous consumption that the whole event ended up being a massive fraud?

Simply taking the time to examine our beliefs about money, wealth and power has the potential to redefine our worldview and change our lives. At a bare minimum we will better understand ourselves. We might also avoid being stranded on Caribbean islands without access to food and shelter.

Investing Like John Wooden

These days it is more or less common knowledge that our brains are not evolved for investment success. In fact, our brains are evolved to keep us from investment success. I don’t have anything profound to say on the science behind this. If you are interested in the science, I would recommend reading Thinking, Fast and Slow, by Daniel Kahneman.

Rather, I want to focus on how we can deal with our evolutionary disadvantages.

There is much investing literature insisting the solution to our cognitive and emotional biases is simply to think as dispassionately and analytically as possible. That sounds nice on paper. However, I don’t think it is realistic. I don’t believe it is possible to completely cut emotion out of the investment process. I would argue that if you think you have successfully removed emotion from your investment process what you have really succeeded in doing is deceiving yourself.

It is both healthier and more productive to openly acknowledge that investing is a difficult, emotional process. Better to channel your emotions toward productive ends than waste time and energy denying they exist.

For me, this means measuring success by the quality of your investment process and the consistency of its implementation–not the daily, weekly, monthly or even annual tape print. If you have a quality process and implement it consistently, and you strive for continuous improvement, you will do okay in the long run.

Think of this as the John Wooden approach to investing:

When Wooden arrived at UCLA for the 1948–1949 season, he inherited a little-known program that played in a cramped gym. He left it as a national powerhouse with 10 national championships—one of the most (if not the most) successful rebuilding projects in college basketball history. John Wooden ended his UCLA coaching career with a 620–147 overall record and a winning percentage of .808. These figures do not include his two-year record at Indiana State prior to taking over the duties at UCLA.

What’s more, Wooden openly shared his secret sauce:

John_Wooden_Success_Pyramid

Here are a couple of the ways I strive to channel emotion into process and not into a self-defeating obsession with outcomes:

  • I keep an investing journal where I document research, investment theses, thesis breaks, trades and post-mortems of exited investments. I will also write own my feelings and views of difficult situations or frustrating outcomes.
  • My emphasis is always on following my process. Making money on random gambles or “lottery ticket” type investments doesn’t count as success. My process does not revolve around “making money.” The goal of my process is to validate or disprove investment theses.
  • Thus, selling out of a bad investment is not failure. Exiting bad investments quickly allows me to redeploy that capital into better quality investments. Some of the worst investing mistakes (think Valeant) have been made by people being unwilling to admit they are wrong.

For a process-oriented investor, much of what passes for “investing” seems silly–like poker players on a tilt or dogs chasing cars.

The Problem of Induction

Carpenter's_axe

Imagine you are a chicken. Each day a farmer comes and feeds you. After a few months of this you conclude that whenever the farmer visits, he will bring you food. All the empirical evidence supports this conclusion. Then, on an otherwise unremarkable day, instead of feeding you the farmer chops your head off.

That is a gruesome introduction to the problem of induction. (Though I have heard the chicken example many times I believe it originated with Bertrand Russell)

I have been noodling around with scientific reasoning and logic as relates to investment due diligence. What grates on me is that I have come to believe much of what people are looking to get out of a due diligence process cannot actually be achieved. For example, when we due diligence an investment manager the emphasis is on proving the manager is skilled. In reality we cannot prove this. At best we can conclude it is highly probable a manager is skilled. Alternatively, we can prove a manager is not skilled, provided we define a measure of “skill” in advance.

The average due diligence process is grounded in inductive reasoning. We make observations about the investment manager, her strategy and her firm. If the observations are favorable, we generalize that the manager is likely to be skilled and will perform well in the future. Logically this process is flawed.

The Problem of Induction

I first became aware of the problem of induction several years ago via Taleb’s Fooled By Randomness. The issue is we can only use inductive reasoning to conclude something is “likely” or “unlikely.” We cannot use inductive reasoning to prove something is true or false.

The classic example is the black swan. For a long time people believed all swans were white. They did not know all swans were white (they would have to have observed all the swans in existence to prove this). Rather, people inferred an extremely high probability for all swans being white because all the swans observed to date had been white. Then, in 1697, Willem de Vlamingh discovered cygnus atratus in Australia.

Black_swan_jan09
A black swan; Source: Wikipedia

In the context of investing we struggle with the naïve extrapolation of past performance into the future. On the basis of past performance I can say, “I believe it is probable this investment manager is highly skilled.” However, I cannot use that data to prove, with certainty, that the manager will continue to outperform in the future. This WSJ article hit piece discussing Morningstar ratings is a practical exploration of the issue (although for the record I believe the WSJ badly misrepresented what Morningstar is trying to achieve with its ratings).

The problem of induction is central to the validity of the scientific method. Science does not prove the truth of hypotheses, theories and laws. It merely verifies they are consistent with empirical results. However, as with inferences about the colors of swans, it only takes one false case to disprove a scientific theory. The philosopher Karl Popper therefore concluded falsifiability is the essential criteria determining whether a theory can be considered scientific.

From Wikipedia:

Among his contributions to philosophy is his claim to have solved the philosophical problem of induction. He states that while there is no way to prove that the sun will rise, it is possible to formulate the theory that every day the sun will rise; if it does not rise on some particular day, the theory will be falsified and will have to be replaced by a different one. Until that day, there is no need to reject the assumption that the theory is true. Nor is it rational according to Popper to make instead the more complex assumption that the sun will rise until a given day, but will stop doing so the day after, or similar statements with additional conditions.

Such a theory would be true with higher probability, because it cannot be attacked so easily: to falsify the first one, it is sufficient to find that the sun has stopped rising; to falsify the second one, one additionally needs the assumption that the given day has not yet been reached. Popper held that it is the least likely, or most easily falsifiable, or simplest theory (attributes which he identified as all the same thing) that explains known facts that one should rationally prefer. His opposition to positivism, which held that it is the theory most likely to be true that one should prefer, here becomes very apparent. It is impossible, Popper argues, to ensure a theory to be true; it is more important that its falsity can be detected as easily as possible.

Applications To Due Diligence & Investment Analysis

This means you cannot “prove” an investment thesis is correct. At best you can gather evidence to build conviction that your investment thesis is “probably” correct. In my experience much due diligence is conducted with an inductive mindset. This leaves due diligence processes vulnerable to confirmation bias.

Should we invert the process?

In other words, you would organize due diligence with the goal of falsifying an investment thesis. If the thesis cannot be falsified, you invest. As a risk management discipline, you then establish a series of easily falsifiable statements constituting “thesis breaks” (e.g. “Company A will average double-digit revenue growth over the next 3 years”). When a thesis break is triggered, the investment is re-evaluated or removed from the portfolio.

Practical Considerations

At a high level, evaluating an investment opportunity can almost always be boiled down to the following:

People: Management has integrity and is aligned with investors.

Process: Processes are disciplined, repeatable and based on sound economic principles.

Performance: Past performance supports management’s ability to execute.

The due diligence process should not be structured to verify these statements as accurate. It should be structured to prove they are false. In practice to guide your work you would need to establish a whole series of falsifiable statements underneath these broad headings. For example, under People:

  • Management has never committed or been associated with securities-related offenses.
  • Management has no prior record of personal or business bankruptcy.
  • Management has never been convicted of a felony or misdemeanor offense.
  • Management owns >10% of shares outstanding / maintains significant personal investment.

In my view this is a more straightforward, disciplined and logically sound method of organizing a due diligence process. To a non-practitioner the distinction may seem silly. However, the structure is designed to minimize confirmation bias—a common and dangerous cognitive bias in investment research and portfolio management.

The Pursuit of Truth

Bridgewater Associates has a reputation for being something of a cult. I do not have direct experience with Bridgewater or its founder Ray Dalio other than reading some of their research and thought pieces. So I’m not really qualified to weigh in on the cult aspect. What I do appreciate about Bridgewater’s culture is that it is fanatically process-oriented, to the point of resembling a spiritual quest. Check out these snips:

Principles
Source: Website for Ray Dalio’s Principles
Bridgewater_What_We_Do
Source: Bridgewater Website

Now, this post is not meant as Bridgewater commercial. Bridgewater is simply a real-life example of firm that seeks to understand Truth, and has reaped the benefits of the process. If you understand the Truth of how the world operates, making money using that knowledge is trivial.

This might seem like a banal observation. I promise it is not. In my view a majority of investment organizations have it backward. They are focused on outcomes. The Truth of what caused those outcomes is irrelevant. It is easier from a business perspective to simply rationalize things in ways that appeal to clients. It is clients who pay the bills, after all.

The result is that investing becomes an endless performance chase. This is the finance equivalent of Buddhist samsara. It is an endless cycle of birth, suffering and death.

By now you might think I am off the deep end. Yet I am not the first person to connect practical issues in asset management to broader philosophical concepts. Patrick O’Shaughnessy has written an excellent post covering related subject matter, “Two Star Managers and the Wheel of Fortune.” In it he shares this Taoist story:

There is a Taoist story of an old farmer who had worked his crops for many years. One day his horse ran away. Upon hearing the news, his neighbors came to visit.

“Such bad luck,” they said sympathetically.

“We’ll see,” the farmer replied.

The next morning the horse returned, bringing with it three other wild horses.

“How wonderful,” the neighbors exclaimed.

“We’ll see,” replied the old man.

The following day, his son tried to ride one of the untamed horses, was thrown, and broke his leg. The neighbors again came to offer their sympathy on his misfortune.

“We’ll see,” answered the farmer.

The day after, military officials came to the village to draft young men into the army. Seeing that the son’s leg was broken, they passed him by. The neighbors congratulated the farmer on how well things had turned out.

“We’ll see” said the farmer.

As I was writing this I read an excellent piece by Morgan Housel discussing the impact of lived experience on investors’ views of financial markets and investment strategy. It includes this chart:

Morgan_Housel_Investor_Experience_Chart
Source: Collaborative Fund Blog

Here is a bridge from the Taoist story to our lived experience as investors. It illustrates how something as simple as the year we were born can have a dramatic impact on our lived experiences, and by implication our worldview. If we only ever filter the world and the markets through the lens of our personal experiences (and biases), we will see things as we would like to see them rather than how they truly are.

This may blind us to opportunity. It may also blind us to risk. Even thinking of “opportunity” and “risk” as discrete concepts can be reductive and limiting. Typically where there is risk there is also opportunity, and vice versa. This is especially true of investments that are out of favor or misunderstood. To this day, skilled structured credit investors are making good money off toxic mortgage-backed securities originated prior to the financial crisis. Since they have deep, objective knowledge of the securities and the market, they are able to see past the label of “toxic” to the underlying value.

If you can understand the Truth, making money is trivial.

The Wrong Question

Where I work, we are not in the business of stock picking. Nonetheless, clients sometimes ask us to weigh in on individual equities. Often these questions come in the form of “should I buy Oil Company A or Pharma Company B?”

This is the wrong question. Even if you are proceeding from the assumption that stock picking is a worthwhile endeavor, it is the wrong question.

For starters, underlying this question is the assumption that at least one of the two stocks is a good investment. However, it is quite possible (even likely) that neither is a good investment. The entire exercise proceeds from flawed premises.

Unsophisticated investors almost invariably generate investment ideas based on availability bias. They don’t actively seek out non-consensus opportunities. They gravitate toward what they already know, or information that is readily available in the media or in stock picking newsletters (shudder). This in turn leads to “research” driven by confirmation bias.

People who grew up with a grandparent buying blue chip stocks for them like blue chips. People who work in tech like tech. Ditto for aerospace. And so on. This is also why so many people own large amounts of employer stock in their 401(k)s despite the vast body of personal finance literature advising otherwise. No ex ante consideration is given to risk management or opportunity cost–what the investor could earn in a broadly diversified equity portfolio.

Another problem with the question “should I buy Oil Company A or Pharma Company B?” is it completely ignores the issue of time horizon. Do you plan on holding this stock forever? For three years? For one year? For a couple of quarters? A day? As Cliff Asness is fond of saying, you don’t want to be a momentum investor on a value investor’s time horizon.

I consider myself a value-oriented investor, but I would bet on momentum over value for short time periods. In response to a question about performance evaluation, I once told a colleague I would be comfortable owning a certain mutual fund for the next 20 years, but not for the next 5. My statement was met with uncomfortable silence. From his reaction you would think I had spoken a koan. (I guess maybe I did)

I could go on by delving into financial statement analysis, but that’s beside the point. By using “should I by Oil Company A or Pharma Company B?” as a jumping off point you are skipping steps. You are making a security selection decision divorced from any larger context or purpose.

In other words, you are gambling.

Now, the purpose of this blog is not to admonish people for gambling. I enjoy the occasional negative expectation game as much as the next person. However, it is hazardous to your wealth to conflate gambling and investing.

The First Mutual Fund

Vereinigte_Ostindische_Compagnie_bond
Dutch East India Company bond from 1623; Source: Wikipedia

Today the mutual fund industry is a multi-trillion dollar business. It is amazing to think these structures, and other innovations we think of as “modern,” such as asset-backed securities, have their origins in the 18th century.

The material in this post is summarized from an article contained within a 2016 collection of essays, Financial Market History: Reflections on the Past for Investors Today, from the CFA Institute Research Foundation. Specifically, this material is from Chapter 12, “Structured Finance and the Origins of Mutual Funds in 18th-Century Netherlands,” by K. Geert Rouwenhorst.

You really ought to read the whole piece as it contains a wealth of fascinating information not summarized here. If you are the kind of person who is fascinated by the idea of structured finance for colonial plantations, that is.

Anyway, the first mutual fund was launched in 1774 by a Dutch broker and merchant, Abraham van Ketwich. Its name, Eendragt Maakt Magt (“Unity Creates Strength”), goes to show that fluffy marketing copy is as old as the asset management business itself.

Rouwenhorst sets the scene:

The first mutual fund originated in a capital market that was in many ways well developed and transparent. More than 100 different securities were regularly traded on the Amsterdam exchange, and the prices of the most liquid securities were made available to the general public through broker sheets and, at the end of the century, a price courant. The bulk of trade took place in bonds issued by the Dutch central and provincial governments and bonds issued by foreign governments that tapped the Dutch market. The governments of Austria, France, England, Russia, Sweden, and Spain all came to Amsterdam to take advantage of the relatively low interest rates. Equity shares were scarce among the listed securities, and the most liquid issues were the Dutch East India Company, the Dutch West India Company, the British East India Company, the Bank of England, and the South Sea Company. The other major category of securities consisted of plantation loans, or negotiaties,as they were known in the Netherlands. Issued by merchant financiers, these bonds were collateralized by mortgages to planters in the Dutch West Indies colonies Berbice, Essequebo, and Suriname.

The investment strategy and terms went something like this:

Investment Strategy

The fund’s objective is to generate income through investment in a diversified global bond portfolio.

To achieve its objective, the fund will invest approximately 30% of its assets in plantation loans in the British colonies, Essequebo and the Danish American Islands. The remaining 70% of its assets shall be invested in a broadly diversified portfolio of issuers including European banks, tolls and canals.

The fund shall also conduct a lottery, whereby a certain portion of dividends will be used to repurchase investors’ shares at a premium to par value, and to increase dividends to some of the remaining shares outstanding. (You know, just for fun)

Share Classes

The 2,000 shares of the fund shall be divided into 20 classes, each to be invested in a portfolio of 50 bonds. Each class shall contain 20 to 25 different securities to ensure a diversified portfolio.

Custody & Administration

The investment advisor (Van Ketwich) shall provide a full accounting of investments, income and expenses to all interested parties no less than annually.

The securities owned by the trust shall be held in custody at the office of the investment advisor. Specifically, securities shall be stored in a heavy iron chest that can only be unlocked through the simultaneous use of separate keys controlled by the investment advisor and a notary public, respectively.

Expenses

The investment advisor shall receive an up-front commission of 50 basis points upon the initial sale of fund shares, and thereafter an annual management fee of 100 guilders per class of securities.

Rouwenhorst argues the driving force behind the creation of the fund was investor demand for portfolio diversification. To purchase a diversified portfolio of bonds would have been prohibitively expensive for small investors of the day. These investors may also have been gun shy following a financial crisis in 1772-1773, which nearly triggered defaults by several brokers.

Nonetheless, the fund endured a tumultuous trading history. By 1811 it was trading at a 75% discount to par (!) and was eventually liquidated in 1824, after making a final distribution of 561 guilders. Interestingly, Rouwenhorst notes that the fund actively repurchased shares when they traded at a discount–what looks to be an early form of closed-end fund arbitrage.

I do not have anything especially profound to conclude with here, other than to observe that financial markets have been complex and global in nature for quite some time. The first mutual fund is a perfect example.

Finding a Place in the Market Ecosystem

In my market ecosystem post I described different types of investors and the roles they might play throughout an idealized company’s life cycle. Writing that post caused me think more deeply about my own investing philosophy and the role I play in the market ecosystem (this is one of the reasons I write).

I used to think of myself primarily as a value investor: someone who is out there looking to pick up dollars for fifty cents. There is a still a part of me that is deeply attracted to these types of investments due to the margin of safety they afford.

However, another part of me is attracted to compounding machines. In order for an investment to compound over time it needs to generate high returns on capital and also offer ample opportunity to reinvest that capital for similarly high returns. This is identical to the reinvestment assumption underpinning the IRR and YTM calculations.

Traditional value investments may not compound very well. Many are maybe single digit revenue growers but with strong free cash generation. What keeps them from compounding at high rates is that the cash cannot be reinvested in growth initiatives (maybe the market is mature). Even worse, a management flush with cash may start doing stupid things to “buy” growth (such as play venture capitalist).

However, compounding machines tend to be more expensive than traditional value investments. It can be tough to find them with a fat margin of safety, particularly these days when valuations across the quality spectrum are stretched. This is mitigated somewhat by the fact that it is easier psychologically to hold a compounding machine for a very long time. A compounding machine by definition merits a richer valuation.

Therefore, what are more and more interesting to me are businesses that have reached inflection points. Ideally these are businesses that have been dumped by growth investors and are at increasing risk of being dumped by value investors but where the business nonetheless has a reasonable probability of inflecting positively. Low debt levels are important here as leverage can be catastrophic for a business in transition.

Here are some reasons I like this approach:

  • These businesses tend not to screen well on backward-looking quantitative measures. This makes them more likely to be overlooked and less likely to be owned by sophisticated investors facing pressure to deliver strong relative performance versus benchmarks (active mutual fund managers, pension funds, endowments). Taking a position in a stock at an inflection point introduces significant career risk into the equation for these players.
  • These businesses usually face significant uncertainty, which causes their market valuation to overshoot and undershoot significantly relative to intrinsic value.
  • If you fish for these businesses in the smaller cap segment of the market (under $1 billion and preferably $250 million or less) that is an additional constraint on large institutional investors that contributes to a structurally inefficient market niche.
  • If you are able to fish in the niche described above, the trading volumes for these stocks can be thin which means the price gets bounced around whenever someone buys or sells. This may present attractive buying opportunities as you build a position (but it can hurt if you need to exit the position in a hurry–another example of the advantages conferred by a permanent capital base).

The biggest risk to this investment approach is buying into a value trap. Thus, that ought to be the central focus of a risk management discipline. I am pondering how best to codify this but I think it starts with the decision to average down.

To summarize some valuable insights from John Hempton (whose portfolio management discipline I admire), one should never average down any of the following:

  • High leverage (financial or operational)
  • Technological obsolescence
  • Potential fraud

Related concepts I have been examining are use of the Kelly Criterion in position sizing and implementing some kind of explicit Bayesian updating process. Details to  be determined and perhaps discussed in a future post.