Portfolio Construction In A Frightening And Uncertain World

My last post on risk management was somewhat impractical. It was critical of the shortcuts we often take in analyzing risk but didn’t offer anything in the way of practical alternatives.

The theme of the last post was that in spite of the sophisticated-sounding calculations underlying most analyses, they are at best crude approximations. In general, these approximations (e.g. assumption of uncorrelated, normally distributed investment returns) make the world seem less risky than it really is.

So, what are we supposed to do about it?

In theory:

  • We should take even less risk than our statistical models indicate is acceptable, building in an extra margin of safety. For example, holding some cash reserves even if we have the risk tolerance to run fully invested.
  • We should use leverage sparingly.
  • We should not make overly concentrated bets. I’m not just talking about individual stocks here. The same goes for securitized asset classes like US large cap stocks.
  • We should not have too much conviction in any given position.

Also, in theory, the more certain you are of an investment outcome, the larger and more concentrated you should make your positions. If you knew the future with total certainty, you would go out and find the single highest return opportunity out there and lever it to the max.

Given we live in a world where a 60% hit rate is world class, most of our portfolios should be considerably more diversified with considerably less than max leverage.

I don’t think any of that’s particularly controversial.

But I’m not just talking about individual stocks here. This goes for broad asset classes and the notion of “stocks for the long run,” too. I’m not arguing we should all be capping equity exposure at 50%. But it’s prudent to stress portfolios with extreme downside scenarios (this is unpopular because it shows clients how vulnerable they are to severe, unexpected shocks).

How robust is the average retiree’s portfolio to a 30% equity drawdown that takes a decade to recover?

For that matter, how robust is the average retiree’s portfolio to 1970s-style stagflation?

Jason Zweig interviewed a couple of PMs who had to endure through that period:

“It was so painful,” says William M.B. Berger, chairman emeritus of the Berger Funds, “that I don’t even want my memory to bring it back.” Avon Products, the hot growth stock of 1972, tumbled from $140 a share to $18.50 by the end of 1974; Coca-Cola shares dropped from $149.75 to $44.50. “In that kind of scary market,” recalls Bill Grimsley of Investment Company of America, “there’s really no place to hide.” Sad but true: In 1974, 313 of the 318 growth funds then in existence lost money; fully 123 of them fell at least 30%.

“It was like a mudslide,” says Ralph Wanger of the Acorn Fund, which lost 23.7% in 1973 and 27.7% more in 1974. “Every day you came in, watched the market go down another percent, and went home.”

Chuck Royce took over Pennsylvania Mutual Fund in May 1973. That year, 48.5% of its value evaporated; in 1974 it lost another 46%. “For me, it was like the Great Depression,” recalls Royce with a shudder. “Everything we owned went down. It seemed as if the world was coming to an end.”

Are we building portfolios and investment processes taking the possibility of that kind of environment into account?

Are we equipped psychologically to deal with that kind of environment?

I conclude with this evocative little passage from George R.R. Martin:

“Oh, my sweet summer child,” Old Nan said quietly, “what do you know of fear? Fear is for the winter, my little lord, when the snows fall a hundred feet deep and the ice wind comes howling out of the north. Fear is for the long night, when the sun hides its face for years at a time, and little children are born and live and die all in darkness while the direwolves grow gaunt and hungry, and the white walkers move through the woods.”

Alignment of Interests

Recently, someone argued to me it’s not good if your personal portfolio looks too different from what you recommend to clients as a financial advisor. Generally, I disagree. However, there are certainly limits. If you are selling your ability to “pick winners” to clients and your portfolio is all index funds, for example, that is a problem.

If I am acting as a fiduciary, I am to act in clients’ best interests. Most clients will look nothing at all like me in terms of their goals, financial circumstances, risk tolerance and level of financial sophistication.

The biggest difference between me and a client would probably be our relative tolerance for tracking error. That is, our tolerance for investment performance that is very different from the broad market indices and our neighbors, who are inclined to chase momentum and do stupid things like borrow money to buy Bitcoin at the top.

Everyone wants to be +20 when the market is +10, or breaking even when the market is -10. No one likes being -5 when the market is +5.

Oddly, the pain of being -5 when the market is +5 seems more acute for clients than being -10 when the market is -10. For the client, the right thing to do is minimize tracking error and the pain of relative underperformance to make it easier for him to stick to his asset allocation and financial plan more generally.

What is more important than the optics of my portfolio is the alignment of interests in the advisor-client relationship. My financial incentives should be structured such that I am at all times incentivized to make decisions in my clients’ best interest.

Two And Twenty

Some people claim the hedge fund two and twenty (that is, a two percent management fee and twenty percent of profits) fee structure aligns the managers with their clients. This, too, is nonsense. It is a totally asymmetric payoff for the manager. The manager suffers nothing if performance is poor. The compensation structure is a free option that encourages excessive risk taking. That’s why it’s extra important for hedge fund managers to be personally invested in their funds and “eat their own cooking.” It creates symmetry in the incentive structure.

A financial advisor is not a hedge fund manager.

A hedge fund manager should be entirely focused on investment performance (here I am including risk management under the umbrella of performance). For a financial advisor, investment performance is at least two or three lines down the list, well below things like cash flow management and asset allocation. If a client is not generating free cash flow even Buffett’s returns won’t save him. Likewise, a client who is inclined to whipsaw herself to death trying to time the market will not benefit from clever security selection.

Increasing clients’ saving rates and dissuading clients from market timing have nothing whatsoever to do with the composition of the advisor’s investment portfolio.

Shenanigans! “Index Investing Distorts Valuations” Edition

Here is an oft-repeated meme that has begun to grind my gears. Here it is again, from the FT’s Megan Greene:

Passive investments, such as exchange traded funds (ETFs) and index funds, similarly ignore fundamentals. Often set up to mimic an index, ETFs have to buy more of equities rising in price, sending those stock prices even higher. This creates a piling-on effect as funds buy more of these increasingly expensive stocks and less of the cheaper ones in their indices — the polar opposite of the adage “buy low, sell high”. Risks of a bubble rise when there is no regard for underlying fundamentals or price. It is reasonable to assume a sustained market correction would lead to stocks that were disproportionately bought because of ETFs and index funds being disproportionately sold.

The idea that index investors cause valuation disparities within indices is a myth. It is mainly trotted out in difficult client conversations about investment performance. For the purposes of this discussion, let’s restrict the definition of “passive” to “investing in a market capitalization weighted index,” like the Russell 2000 or S&P 500. There is a simple reason everyone who makes this argument is categorically, demonstrably wrong:

INDEX FUNDS DON’T SET THE RELATIVE WEIGHTS OF THE SECURITIES INSIDE THE INDEX. 

It is correct to say things like, “S&P 500 stocks are more expensive than Russell 2000 stocks because investors are chasing performance in US large caps by piling into index funds.”

It is correct to say things like, “S&P 500 stocks are more expensive than OTC microcaps outside of the index because investors are chasing performance in US large caps by piling into index funds.”

It is demonstrably false to say, “NFLX trades at a ridiculous valuation relative to the rest of the S&P 500 because investors are chasing performance in US large caps by piling into index funds.”

Index funds buy each security in the index in proportion to everything else. Their buying doesn’t change the relative valuations within the index.

Here is how index investing works:

1. Active investors buy and sell stocks based on their view of fundamentals, supply and demand for various securities, whatever. They do this because they think they are smart enough to earn excess returns, which will make them fabulously wealthy, The Greatest Investor Of All Time, whatever. As a result, security prices move up and down. Some stuff gets more expensive than other stuff.

2. Regardless, the markets are not Lake Wobegon. All of the active investors can’t be above average. For every buyer there is a seller. If you average the performance of all the active investors, you get the average return of the market.

3. Index investors look at the active investing rat race and think, “gee, the market is pretty efficient thanks to all these folks trying to outsmart each other in securities markets. Let’s just buy everything in the weights they set. We are content to get the average return, and we will get it very cheaply.”

4. Index investors do this.

Despite what we in investment management like to tell ourselves, index investors are rather clever. They are trying to earn a free lunch. They let the active investors spend time, money and energy providing liquidity and (to a much lesser extent) allocating capital for real investment in primary market. They just try to piggyback on market efficiency as cheaply as possible.

In my experience, some index investors like to think of themselves as somehow acting in opposition to active managers. This, too, is demonstrably and categorically false. Index investors’ results are directly and inextricably tied to the activity of active investors setting the relative weights of securities within the indices. That activity is what determines the composition of the index portfolio.

It’s a symbiotic relationship. Index investing only “works” to the extent the active investors setting the relative weights within the index are “doing their jobs.” When the active managers screw up, bad companies grow in market capitalization and become larger and larger weights in the index. At extremes, the index investor ends up overexposed to overvalued, value-destroying businesses. This happened with the S&P 500 during the dot-com era.

Now, flows of passive money certainly can distort relative valuations across indices, and, by association, across asset classes. When it comes to asset allocation, almost everyone is an active investor. Even you, Bogleheads. Otherwise you would own something like ACWI for your equity exposure.

A running theme of this blog is that there are no free lunches. Someone is always paying for lunch. These days, it’s the active managers. But that doesn’t mean the passive folks will always enjoy their meal.

Great Expectations

Not a good day for FANG. Facebook in particular:

180726_FB
Source: Google

Let’s cut to an investor reaction shot, courtesy of the FT. This made me laugh so hard I had to screencap it for posterity:

180726_FT_FB_Quote
Source: Financial Times

Uh oh. Looks like someone was just plugging management guidance into her model. Or forgot to fade revenue growth and returns on capital. Or both.

Look. Schadenfreude aside, FB is a good business with a good product. As far as I’m concerned, the jury’s out on the valuation (of the so-called FANG stocks I have very strong opinions on NFLX and AMZN, but not so much on GOOG and FB). I have no real opinion on the long-run prospects for the business. Today’s price action is simply a helpful reminder that good businesses selling good products can still be bad investments if you overpay.

In my experience, that last bit is the hardest thing about investing for laypeople to understand. Most people understand what makes a good product. Somewhat fewer understand what makes a good business. But almost no one outside finance understands why overpaying can overwhelm everything else.

Let’s explore this further. Here is the most important chart in all of fundamental investing:

justified_pe_fade
Source: Demonetized Calculations

What are you looking at?

You’re looking at the valuation life cycle of a business (an exceptional one, btw) with the following characteristics:

 

justified_pe_fade_inputs

I generated the graph with a simple model called a fundamental H model. In an H model, a company’s life is divided into two parts: an “advantage period” featuring excess growth and returns on capital, and a “steady state” period where the company simply earns its cost of capital.

The intuition here is really, really simple. It’s so simple I’m not going to bother going into the details of what an H model actually looks like.

Ready?

Companies with exceptional growth and profitability attract competitors. Competition decreases profitability and slows growth (more companies are fighting over the same pool of customers). As competition drives down future growth and profitability, every company in the space becomes less valuable. Or, in another variation, a market simply becomes saturated, and there is very little growth left available. Or, new technology is developed that makes a company obsolete. You can go on and on. The variations are endless.

Some businesses are better at defending their profitability and growth (they have “moats”). If you are good at identifying strong moats, you can make a lot of money. This has worked out well for Warren Buffett. Especially since he was able to lever his bets with insurance float. All else equal, you should be willing to pay more for a business with a “wide moat.” How much? Believe it or not, figuring that out is the fun of it. It’s the game all of us long-term, fundamental investors are playing.

Likewise, in some industries with only a few large players, the players are smart enough to realize they should protect their profit pools, not undercut their competitors on price just to gain market share (this is uncommon).

Also, it’s technically possible to grow your way out of a contracting valuation. If the E in P/E grows large enough, fast enough, you can still make money even if the ratio shrinks. You could have paid several hundred times earnings for WMT stock back in the day, and still made money. But only a select group of businesses have this ability, and personally I think they are far more difficult to spot ex ante than people like to admit.

Anyway, all that’s beside the point.

The point is that growth and profitability inevitably fade to some degree. And when they do, valuations de-rate. When people overpay for businesses, what they are doing (whether they realize it or not) is being overly optimistic about the magnitude and the rate of the fade.

Basically, they are forgetting how capitalism works.

Disclosure: Small positions in FB and GOOG, via a mutual fund manager. But less than 1 bp on a lookthrough basis. So, practically speaking, no positions in anything referenced in this post.

Live By The Sword, Die By The Sword

Good management teams are first and foremost good storytellers. They’re shapers of reality. I don’t care whether you’re Warren Buffett, Elon Musk or Reed Hastings. If you are the Big Guy (or Big Gal) most of your job is storytelling. You spend most of your time telling stories to your stakeholders. Employees. Customers. Investors.

What’s truly amazing about Reed Hastings’s ability as a CEO/storyteller is how he’s managed to make Netflix’s free cash flow burn irrelevant. Here’s a screenshot directly from the company website:

NFLX_FCF_FAQ
Source: NFLX website

This is a company burning billions in cash a year, that is utterly dependent on the amity and goodwill of the capital markets (specifically, the high yield debt market) to support its continued existence.

And no one cares.

The reason no one cares is Reed Hastings is a great CEO/storyteller. He’s convinced the market it’s subscriber growth and not free cash flow that matters.

Well, yesterday NFLX (badly) missed expectations for subscriber growth. The result?

NFLX_180716_Price
Source: Google

Live by the sword, die by the sword, as the saying goes. This is the kind of reaction you get when you train the market on a certain narrative, and then that narrative is called into question. The market freaks out.

This is something short sellers understand deeply and intuitively. If you are a short seller who doesn’t understand this deeply and intuitively, you’re not going to last very long.

A short needs to understand the narrative driving a stock. The time to short a stock is when the narrative breaks. When a narrative breaks, investors start casting around, looking for a new narrative. If the CEO can’t get control of the narrative again, they might start to fixate on things like profitability and cash flows and leverage.

Of course, a good management team will have a new narrative ready to go to replace the old one. In NFLX’s case, they are talking about the limitations of their internal forecasting methods. Short selling is a hard life.

I literally have no opinion on NFLX’s subscriber growth numbers. But I do understand the narrative around them, and the purpose it serves.

Once you start looking for this stuff, you see it everywhere. Tesla is the best example, but it’s a more controversial stock than NFLX. The reason Elon Musk is coming apart at the seams is he’s losing control of TSLA’s narrative. That’s bad for TSLA, which is going to have to pay down or refi about $7 billion worth of debt in the next couple of years.

For these large cap cash incinerators, narrative is a matter of life and death.

Disclosure: No position in either NFLX or TSLA.

Pop Quiz, Hotshot

“Pop quiz, hotshot. There’s a bomb on a bus. Once the bus goes 50 miles an hour, the bomb is armed. If it drops below 50, it blows up. What do you do?”

This is literally the second act of the movie Speed. Never seen Speed? You’re missing out. It’s a pretty hokey movie, truth be told. Funnily enough, it is mostly concerned with decision-making under uncertainty.

We have our own version of this pop quiz in investing, and we are tested regularly. The quiz goes something like this:

“Pop quiz, hotshot. You hold a 10% position in [whatever]. It draws down [a lot]. Average down? Sell? Or hold? What do you do?”

I don’t think you should ever own anything without being able to answer that quickly and succinctly. It’s a good test of whether you understand what you own. If you don’t know what you own, a violent drawdown will shake you out of the position. Likewise, repeatedly averaging down losers is a recipe for bankruptcy. Conviction gets you nowhere if all your ideas suck.

A while back, John Hempton explored the pitfalls of averaging down pretty comprehensively. He wrote, in part:

At a very big picture: averaging down when you are right is very sweet, averaging down when you are wrong is a disaster.

At the first pick the question then is “when are you wrong?”, but this is a silly question. If you knew you were wrong you would never have bought the position in the first place.

So the question becomes is not “are you wrong”. That is not going to add anything analytically.

Instead the question is “under what circumstances are you wrong” and “how would you tell”?

So “know what you own” is Level 1 advice. Level 2 runs along these lines: “how do I know if I’m wrong about what I believe I know about what I own?” (There’s no point in asking how you know if you’re right about what you own. You can’t prove a positive with inductive reasoning)

An Embarrassing Example

One of the first stocks I ever bought turned out to be a classic value trap. I got suckered so bad I actually averaged it down after a dividend cut. I had been seduced by a stock that was statistically cheap and statistical cheapness overrode my objectivity. In reality the dividend cut said everything I needed to know. The nature of the position had changed. The stock had crossed over from a value play to a deep value or even distressed situation. I had not underwritten a distressed situation. This was the “tell” that I was wrong and I missed it (badly).

In fact, to date all of my worst mistakes have come from trying to catch falling knives. Going forward the goal isn’t to avoid these mistakes completely. That’s not realistic. Rather I need to be extra careful about minimizing the damage when they occur. That’s what the pop quiz is all about.

Skin In The Game

I am paid to evaluate investment managers for a living. In doing so I’ve come to believe you aren’t really qualified to sit in judgement of money managers without going through the exercise yourself. When you underwrite a name yourself and have to watch it sell off 20% on a quarterly earnings miss and make the add/trim/sell decision and feel the hit to your own net worth you develop a new and healthy appreciation for investment processes.

You then begin to cultivate two other important qualities: empathy and enhanced BS detection.

Empathy is important because investing is an activity where things can go against you for a long time, and for no particularly good reason. If you are going to hire and fire managers based solely on statistical performance reviews and rankings versus peers you will end up chasing your tail. When you can look at the world through the eyes of the people you are evaluating you realize the right decision is usually to be patient.

Enhanced BS detection is important for obvious reasons. However, people are worse at BS detection than you might think. Investment managers tend not to be complete idiots. In fact they have a habit of dazzling you with their brilliance. Everything always sounds great on paper and in pitch meetings. And yet out in the wild things have a habit of going horribly awry.

Listening to real estate people talk, for example, you would think everyone who has every done a real estate deal has earned a 30% compound annual return with no risk. Yet, real estate investments go to zero all the time.

This doesn’t happen because the real estate itself ends up worthless. It happens because you’re levered maybe 4x into the deal and there is a delay in the project or a hiccup in occupancy and, oops! the debt ahead of you in the cap structure is about to mature. So some enterprising soul comes in with a slug of equity and dilutes you to the point where you’re unlikely to make any money. Or she demands a massive preferred return, with the same result.

Anyway, after getting hosed on a couple “can’t miss” opportunities you wise up. You begin to appreciate just how unfair the universe can be in dishing out random dollops of catastrophic loss. Risk management becomes a bit more intuitive. You are more humble about your ideas, your intelligence and your fallibility.

You don’t get that from reviewing manager peer group rankings.

You get it from risking (and, occasionally, incinerating) real dollars of your own net worth.