A Koan

I’ve been reading Zen stories lately, and even trying my hand at amateur koan introspection. Ben’s latest Epsilon Theory note opens with a story that makes for an interesting koan. Here’s the story:

Back in the day, the long/short hedge fund I co-managed was part of a larger long-only asset manager. Their biggest strategy was US mid-cap value, and it was well staffed with a bevy of really sharp analysts and PMs. But the firm also had a $4 billion US large-cap strategy that was managed by all of two people – the firm’s co-founder as PM, plus a single analyst position that was something of a revolving door … people would come and go all the time in that seat.

The solo analyst’s job, as far as I could tell, was basically to go to investor conferences and to construct massive spreadsheets for calculating discounted cash flow models for, like, Google. And sure, Google would be in the portfolio, because Google MUST be in a large-cap portfolio, but it had nothing to do with the literally hundreds of hours that were embedded in this sixty page spreadsheet. I mean … if the firm’s co-founder/PM spoke with the analyst more than once per week about anything, it was an unusual week, and there’s zero chance that he ever went through this or any other spreadsheet. Zero.

Now to be clear, I think the firm’s co-founder was a brilliant investor. This guy GOT IT … both in terms of the performance of portfolio management and the business of asset management. But here he was, managing a $4 billion portfolio with one ignored analyst, and it was working just fine.

And here’s my koan-version:

A portfolio manager was doing a fine job managing a $4 billion stock portfolio.

A single analyst worked under him, coding up elaborate fundamental models of portfolio companies. The portfolio manager never spoke to the analyst, nor reviewed the models he created.

Over the years, many analysts came and went. It was always the same story with them. But the portfolio continued on in the same way. It was working just fine.

The Eye of the Beholder

MasonicEyeOfProvidence

Securities represent different things to different people over different time horizons.

Over very long time horizons, common stocks represent residual claims on assets and cash flow and will trade accordingly.

Over different time horizons, common stocks can represent other things, and their “meaning” will vary across market participants. Sometimes a stock is a correlation. Sometimes it’s an industry exposure. Sometimes it’s liquidity (or the absence of liquidity).

You’ll often hear traders, analysts and portfolio managers say “such-and-such trades as a whatsit.” What they’re talking about is the dominant meaning of the security in the minds of market participants at a particular point in time.

For fundamental investors, valuation multiples are straightforward examples. They’re quantitative markers of meaning. Embedded in every valuation multiple are assumptions about a business. Everyone reading this post is probably familiar with the price/earnings ratio. Like all multiples, a “justified” version of the P/E can be constructed out of several fundamental data points.

In the case of the justified P/E, we have:

Justified P/E = Dividend Payout Ratio / (Cost of Equity – Dividend Growth Rate)

We can decompose other multiples in similar ways. Ultimately, the exercise boils down to a handful of key variables: margins; returns on capital; reinvestment needs and opportunities; a measure of opportunity cost to the investor (discount rate). Of course, a reasonably perceptive investor also realizes returns on capital are unlikely to remain static over time. You’ve got to account for the impact of competition and market saturation. How aggressively should you fade growth and profitability? The answer to that is probabilistic. It’s where qualitative judgments about a business and its management are made and then transformed into quantitative inputs.

Narrative exists at the intersection of subjective, qualitative judgments and “hard data.” Likewise, it’s at this intersection of subjective, qualitative judgments and hard data that reflexivity operates.

Aswath Damodaran does a fantastic job of recognizing this whenever he values a stock. For an example, you can look at his Lyft valuation. You can agree or disagree with his view of Lyft. What I appreciate about his approach is that it’s explicit about incorporating Narrative, and tying his quantitative assumptions to his qualitative ones.

I’m using Narrative with a capital N here because I’m not talking about spin. I’m talking about meaning. It’s easy for a reasonably competent analyst or portfolio manager to see through spin. Scammy penny stock newsletters are full of spin. Sell-side research, taken at face value, is full of spin. Spin is straightforward to test with a research process. Spin is amenable to number crunching. Developing the vision to see through spin is table stakes in both trading and investing.

Meaning, on the other hand, is necessarily more nuanced. Meaning is reflexive. Because it’s reflexive, meaning isn’t straightforward to test with a research process. It’s Schroedinger’s Cat. The cat is both alive and dead until you look inside the box. A company is both a value play and a value trap until events run their course. A stock is both a buy and a sell until the price moves decisively in one direction or another. The trading action around every stock reflects a dynamic dialogue between buyers and sellers about meaning. Sometimes, in the case of an Herbalife or a Tesla, dialogue escalates into a shouting match. In markets as in real life, shouting matches exhibit different dynamics than measured dialogues. You trade a shouting match differently than you trade a dialogue. Particularly if you’re short.

As far as your P&L is concerned, price is the arbiter of truth. Price is the only truth that matters. For all its faults, technical analysis is spot-on in emphasizing this.

“Dead money” stocks lack meaning. They lack strong, directional Narrative. They’re neither longs nor shorts. They’re empty vessels, drifting listlessly in the markets. To “work” in either direction, a stock requires a Narrative. To borrow the language of a technician, a stock without a clear directional Narrative is a stock that’s “consolidating” or “range-bound” between strong levels of support and resistance. Of course, you can still make money off these stocks. The trick is to see them as trades rather than investments–to see your position as a bet for or against the emergence of a strong directional Narrative.

This also helps explain why well-covered, large cap stocks still exhibit significant price volatility. It’s precisely because they’re well-covered. They’re perfect vessels for Narrative. Prices don’t swing on data so much as changes in the meaning of the data.

The following conditions must be present for strong directional Narratives to emerge:

A coherent and compelling qualitative story
Quantitative data supportive of the story
A missionary (or missionaries) with credibility and reach telling the story

Together, these conditions are reflexive. They can exhibit both positive and negative feedback loops. Investment manias (dot-coms, cryptocurrency) are special cases involving especially powerful feedback loops. I am thinking of writing up a “case study” or two in the next couple of weeks to flesh this out in more concrete terms.

Having Bought The Dip…

The Fed’s 4Q18 Z1 data is out so I am able to update this little model of prospective 10-year returns for the S&P 500. If we could run this again today I suspect it’d be forecasting about 6-7% for the next 10 years, given how we’ve rallied in 1Q19. Not spectacular but not awful, either. Clearly, in the aggregate we bought the dip.

4Q18_SP_ER — Data Sources: Federal Reserve Z1 Release & Demonetized Calculations

Below is the latest expected returns bar chart from RAFI. Definitely a less optimistic picture for US large cap equities, but I believe this is a (small) improvement over the last time I checked it. The “obvious” relative value play is of course ex-US equity and emerging market equity in particular. I put “obvious” in scare quotes here because there are real risks to tilting a portfolio this way, as I’ll discuss a bit more below.

20190308_RAFI — Source: Research Affiliates

This is merely a brief analytical exercise for perspective. Like all models, these ones have weaknesses. The most significant, in my view, is they’re not “macro aware.” For example, the S&P 500 model above would not have given you any warning of the global financial crisis. Today, as far as the differences in relative valuation between US and ex-US equities are concerned, we live in a time where there is a strong argument to be made that globalization is unraveling. And if globalization truly unravels, the intuition underlying global equity investing unravels along with it.

The two risks I worry most about these days?

Geopolitical fragmentation. Taken to a certain extreme, this would break the idea of a globally diversified equity portfolio.

A major spike in inflation. This would break the traditional 60/40 portfolio, at least in real terms.

These risks don’t just represent asset price volatility. They represent regime changes. They represent changes in the relationships between financial assets–changes in financial gravity. My friend Ben Hunt has written what I think is the best piece about what an inflationary regime change means for investors. The short version is that it’s the death of the long bond as an effective diversifier.

Geopolitical risk is trickier. I’m extremely skeptical anyone can effectively handicap geopolitical risk. It’s not something you predict. It’s something you observe. You deal with it when it manifests in the real world, as it happens. Of course, in theory you can hedge this kind of risk. The folks who sell this protection aren’t usually in the habit of giving it away at firesale prices, though I guess it never hurts to check around. Every once in a while you will find something stupid cheap like VIX calls circa 2017 and early 2018.

There is another factor in play here that I don’t consider so much a “risk” as a “force” that acts on everything else. That is fiscal and monetary policymaking–particularly monetary policymaking. Our friendly neighborhood central bankers have made it overwhelmingly clear they intend to remain supportive of financial markets. This will shape the market regime and therefore the relationships between financial assets. Like geopolitical risk, it’s not something you can effectively handicap. As I’ve written elsewhere:

Fed Watching is the ultimate reflexive sport. If you believe there is some kind of capital-T objective Truth to be found in Fed Watching, I am sorry to be the one to tell you but you are one of the suckers at the table. The Fed knows we all know that everyone knows the information content of Jay Powell’s statements is high. (We call them Fed Days, for god’s sake) The Fed plays the Forward Guidance Game accordingly. Sometimes it uses its “data” and “research.” Sometimes it speaks through one of its other hydra heads. The tools and tactics vary, but they’re all deployed to the same end: to shape the subjective realities of various economic and political actors.

I am critical of the current approach to monetary policymaking both in the United States and abroad. However, I do not think shorting the world or sitting 100% in cash or gold is a particularly good strategy. Two reasons:

If the world ends you are probably not going to have much fun collecting on your bet because it will be the end of the global financial system as we know it. You’re better off investing in guns and ammo and maybe a bunker somewhere to express this view.
You are betting against the combined fiscal and monetary policymaking apparatuses of every country in the world. Kind of like shorting a stock where the CEO has unlimited cash available to buy back stock.

Personally, I’m doing my best to balance cautious optimism with a healthy amount of paranoia.

ET Note: The Grand Inquisition

Below is the teaser for my latest Epsilon Theory note. The piece is a meditation on freedom, through the lens of Dostoyevsky’s parable, “The Grand Inquisitor”:

The Nudging State and Nudging Oligarchy believe they are giving us a gift: Freedom from Choice.

Except that it is neither a gift nor freedom in any sense. Rejecting it isn’t always easy and it isn’t always costless. But it’s the only choice for anyone who would be free.

Click through to Epsilon Theory to read the whole thing.

There’s an idea embedded in this note, related to the specific mechanism through which the Nudging State engages in social engineering, which is worth making more explicit. I’ve written around the edges of it before on this blog, in The Tyranny of Optimization, when I wrote:

Here you’re not staring down the barrel of a gun but rather at a smartphone screen. Here, the trick is not only convincing people to buy into your optimization, but that buying in was their idea in the first place. This is tyranny updated for the 21st century. Much cleaner than putting people up against a wall.

What I’m describing here is what my friends at Epsilon Theory call “fiat thought.” These are thoughts and behaviors you believe are your own, though in reality they’ve been engineered by the Nudging State and the Nudging Oligarchy to promote some policy or behavior.

How do you test for fiat thought?

Ask why.

“Why do I believe [whatever]?”

For fiat thought, the answer is always some permutation of “because someone told me so.” Maybe that’s a politician. Maybe it’s a business leader. Maybe it’s a public intellectual or “thought leader.” Maybe it’s a go-to media outlet (or several). Bottom line is you won’t have a principles-based reason for believing whatever is at issue.

Having your thoughts replaced with fiat thought is perhaps the purest form of slavery I can imagine. It’s like being transformed into a pod person, except you don’t even realize the transformation is taking place. In fact, to the extent you notice the transformation at all, you’ll believe it was your own idea. This is the nature of “choice architecture.” It’s a kind of rigged game–a simulation of free will.

In reading some of the responses to my note, there are a couple common threads:

Aren’t constraints on our behavior necessary to some extent to have a functional society?
Most of the folks who serve the State do not have malicious intentions and are sincerely doing the best they can to balance tradeoffs when making policy.

These are both excellent points. I totally agree with both of them.

Constraints on our behavior and incentive systems are terms we negotiate as part of the social contract. The negotiation process is ongoing and dynamic. It never ends. An important aspect of freedom is the ability to participate in the negotiation process as a principal. “Nudgers” do not treat us as principals. Nudgers treat us as biological systems to be engineered.

You Got To Pay To Learn

“A knowledge of cheating methods and the ability to detect them is your only protection against dishonest players in private games. It is for this reason that the most ethical, fastidiously honest card games are those in which the players are top notch gamblers, gambling operators, gambling-house employees and card sharpers. When they play together the game is nearly always honest. It has to be, because they play in an atmosphere of icy distrust, and their extensive knowledge of the methods of cheating makes using their knowledge much too dangerous. They do not cheat because they dare not.

In a money card game patronized by men and women who know little or nothing about cheating techniques, the odds are 2 to 1 that a card cheater is at work.”

John Scarne, Scarne’s New Complete Guide to Gambling (1986)

I came down with some horrible, vaguely flu-like illness recently. Happily, this at least coincided with the arrival of a print copy of Scarne’s New Complete Guide to Gambling. It’s more of a reference text than something you’d read cover to cover. What impressed me most as I leafed through its 800-plus pages was Scarne’s obsession with cheating. In addition to a full sub-section on methods for cheating at card games, nearly every discussion of a game includes a section on common methods for cheating. Rigged games, it seems, are the default state of the universe.

Scarne’s dismissal of carnival wheels is typical of both his logic and wit:

If you want to play carnival wheels for fun, you would be smart to consider that 25% to 50% of the money you wager on each spin is a donation; when you reach the total amount you wish to donate—quit playing.

As you’d expect, in addition to cheating, Scarne was fairly obsessed with edge. Of poker strategy, he writes:

There is one big secret, a Poker policy which, if put to use, will not only make you a winner at your next session but at most of them. It’s a policy that is practiced religiously by the country’s best poker hustlers. It is the only surefire rule that wins the money. It’s a simple rule: Don’t sit in a Poker game with superior players.

There are plenty of ways to apply this rule to investing. It’s well-worn ground in the context of the active/passive debate. I’ve got little to add there. So let’s talk about another application. Let’s talk about deals. Specifically, let’s talk about the “democratization” of deals—how increasingly, private equity and credit strategies are being pitched to wealthy individuals and their financial advisors as important, if not essential, additions to portfolios.

I’m hardly a low complexity, liquid asset teetotaler when it comes to portfolio construction. I happen to believe private market deals offer a rich opportunity set for value-added portfolio management by skilled professionals.

Why? Because we’re talking about a relatively inefficient, illiquid market where the participants are allowed to act on inside information. A real poker game. A wild west poker game, even. I suspect John Scarne would feel right at home at the helm of a PE or VC shop.

And wouldn’t you know it, the dispersion of returns for non-core real estate, private equity and venture capital managers is immense.

JPM_Alt_Manager_Disperion

What is the single most important thing that separates a top quartile manager from a bottom quartile manager?

Deal flow.

To continue with our poker game analogy, in the larger cap areas of public markets you can be reasonably certain the cards have been dealt fairly. Deal flow isn’t an issue there. In private markets, it’s just the opposite. Private markets are about card sharping. Pickup stacking. Riffle stacking. False shuffling. Nullifying the cut. Bottom dealing. There’s a reason certain big firms’ shticks are recruiting a vast army of consultants and partners, many of whom who operate at the nexus of government and business. There’s far too much money at stake here to leave these things to chance.

I have a friend who did a tour as a White House Fellow. Believe me when I tell you the deck is stacked. The big PE shops and consultancies are masters of the riffle stack.

So where does that leave us?

We can either learn to see the angles, or we can decline to play. When it comes to deals, there are plenty of hands not worth playing.

To take a simple example, let’s think about interval funds. These are private equity and credit deals packaged in a mutual fund-like wrapper that can more easily be sold to mass affluent clientele. The pitch is that you, or your financial advisor, can access the private equity “asset class” with more favorable liquidity terms, 1099 tax reporting, and so on. “Private markets for the rest of us,” so to speak.

What’s not to like?

I’ve had the opportunity to discuss these with a couple investment banker types. I always ask the same question: “How can we know the sponsors aren’t just dumping all their worst deals into these retail vehicles as an excuse to charge fees on the assets?”

The answer always comes back: “You can’t.”

And as anyone who’s ever invested in anything even remotely illiquid well knows, favorable liquidity terms are just, like, someone’s opinion. Read the docs! If stuff ever hits the fan, you’ll be gated and locked up like everyone else. No one cares about liquidity when times are good. Everyone wants liquidity when times are bad. The more desperately you want out, the more likely you are to find yourself trapped. This is a timeless axiom of risk management.

Oh, and there’s always the matter of performance evaluation. Deals are sold on the basis of IRR, but “you can’t eat IRR” (it doesn’t measure cash-on-cash returns). So remember to compare IRR to MOIC, and on top of that to look at everything in the context of your original capital commitment, ’cause there’s an opportunity cost to committed capital. You can go on and on with this stuff. We haven’t even gotten to trends for deal multiples, or the dispersion of those multiples across across market segments, or the leverage and coverage levels for those deals, or what any of that might mean for prospective returns…

…so, yeah, there are lots of angles in private markets.

How do you learn to spot them?

The same way you learn to gamble. By playing. By getting fleeced. By losing money. Scarne again:

After twelve hours of gambling, Fat the Butch found himself a $49,000 loser, and he quit because he finally realized something must be wrong with his logic. He was, later, part owner of the Casino de Capri in Havana, and when I told him it would need 24.6 rolls to make the double-six bet an even-up proposition, and that he had taken 20.45% the worst of it on every one of those bets, he shrugged his massive shoulders and said, “Scarne, in gambling you got to pay to learn, but $49,000 was a lot of dough to pay just to learn that.”

I’m not saying you shouldn’t play this game.

I’m saying if you choose to play, you better play to win, and you better be ready to take some hard knocks along the way. DO NOT DABBLE NAIVELY. Because the folks pitching you deals, and their competitors, are definitely playing to win. Winning is their business. I’m not talking narrowly about generating attractive net returns for investors. I’m talking about fee revenue and carried interest. Fee revenue and carried interest are the metagame here. And there’s far too much money at stake to leave that outcome to chance. Regardless of your net returns as an investor.

Since this is a Scarne-inspired note, I’ll give him the last word:

When you play cards, give the game all you’ve got, or get out; not only is that the one way on earth to win at cards, it’s the only way you and the rest of the players can get any fun out of what ought to be fun. You can’t play a good hand well if your mind’s on that redhead down the street or the horses or your boss’s ulcers or your wife’s operation. When you don’t remember the last upcard your opponent picked and you throw him the like-ranked card which gives him Gin, it’s time to push back your chair and say, “Boys, I think I have another engagement.”

The Social Contract

This is a (very) quick note just to record a thought for posterity. In discussing issues of natural rights and the social contract with some friends, I landed on this description of the political process:

Modern society is the output of a long and tortured series of negotiations over how and why we should structure the social contract to limit the nastiness and brutishness of the state of nature.