Mental Model: How To Make Money Investing

In my line of work, I see a lot of client investment portfolios. Very few of these portfolios are constructed from any kind of first principles-based examination of how financial markets work. Most client portfolios are more a reflection of differences in advisory business models.

If you work with a younger advisor who positions her value add as financial planning, you’ll get a portfolio of index funds or DFA funds.

If you work with an old-school guy (yes, they are mostly guys) who cut his teeth in the glory days of the A-share business, you’ll get an active mutual fund portfolio covering the Morningstar style box.

No matter who you work with, he or she will cherry-pick stats and white papers to “prove” his or her approach to building a fairly vanilla 60/40 equity and fixed income portfolio is superior to the competition down the street.

My goal with this post, and hopefully a series of others, is to help clarify and more thoughtfully consider the assumptions we embed in our investment decisions.

So, how do I make money investing?

There are two and only two ways to get paid when you invest in an asset. Either you take cash distributions or you sell the asset to someone for a higher price than you paid for it.

Thus, at a high level, two factors drive asset prices: 1) the cash distributions that can reasonably be expected to be paid over time, and 2) investors’ relative preferences for different cash flow profiles.

What about gold? you might wonder. Gold has no cash flows. True enough. But in a highly inflationary environment investors might prefer a non-yielding asset with a perceived stable value to risky cash flows with massively diminished purchasing power. In other words, the price of gold is driven entirely by investors’ relative preferences for different cash flow profiles. Same with Bitcoin.

So, where does risk come from?

You lose money investing when cash distributions end up being far less than you expect; when cash distributions are pushed out much further in time than you expect; or when you badly misjudge how investors’ relative preferences for different cash flow profiles will change over time.

That’s it. That’s the ball game. You lose sight of this at your peril.

There are lots of people out there who have a vested interest in taking your eye off the ball. These are the people Rusty and Ben at Epsilon Theory call Missionaries. They include politicians, central bankers and famous investors. For ~~some of them~~ almost all of them, their ability to influence the way you see the world, and yourself, is a source of edge. It allows them to influence your preferences for different cash flow profiles.

Remember your job!

If you’re in the business of analyzing securities, your job is to compare the fundamental characteristics of risky cash flow streams to market prices, and (to the best of your ability) formulate an understanding of the assumptions and preferences embedded in those prices.

If you’re in the business of buying and selling securities, your job is to take your analysts’ assessments of cash flow streams, as well as the expectations embedded in current market prices, and place bets on how those expectations will change over time.

Ultimately, as the archetypical long-only investor, you’re looking for what the late Marty Whitman called a “cash bailout”:

From the point of view of any security holder, that holder is seeking a “cash bailout,” not a “cash flow.” One really cannot understand securities’ values unless one is also aware of the three sources of cash bailouts.

A security (with the minor exception of hybrids such as convertibles) has to represent either a promise by the issuer to pay a holder cash, sooner or later; or ownership. A legally enforceable promise to pay is a credit instrument. Ownership is mostly represented by common stock.

There are three sources from which a security holder can get a cash bailout. The first mostly involves holding performing loans. The second and third mostly involve owners as well as holders of distressed credits. They are:

Payments by the company in the form of interest or dividends, repayment of principal (or share repurchases), or payment of a premium. Insofar as TAVF seeks income exclusively, it restricts its investments to corporate AAA’s, or U.S. Treasuries and other U.S. government guaranteed debt issues.

Sale to a market. There are myriad markets, not just the New York Stock Exchange or NASDAQ. There are take-over markets, Merger and Acquisition (M&A) markets, Leveraged Buyout (LBO) markets and reorganization of distressed companies markets. Historically, most of TAVF’s exits from investments have been to these other markets, especially LBO, takeover and M&A markets.

Control. TAVF is an outside passive minority investor that does not seek control of companies, even though we try to be highly influential in the reorganization process when dealing with the credit instruments of troubled companies. It is likely that a majority of funds involved in value investing are in the hands of control investors such as Warren Buffett at Berkshire Hathaway, the various LBO firms and many venture capitalists. Unlike TAVF, many control investors do not need a market out because they obtain cash bailouts, at least in part, from home office charges, tax treaties, salaries, fees and perks.

I am continually amazed by how little appreciation there is by government authorities in both the U.S. and Japan that non-control ownership of securities which do not pay cash dividends is of little or no value to an owner unless that owner obtains opportunities to sell to a market. Indeed, I have been convinced for many years now that Japan will be unable to solve the problem of bad loans held by banks unless a substantial portion of these loans are converted to ownership, and the banks are given opportunities for cash bailouts by sales of these ownership positions to a market.

For you index fund investors snickering in the back row—guess what? You’re also looking for a cash bailout. Only your ownership of real world cash flow streams is abstracted (securitized) into a fund or ETF share. In fact, it’s a second order securitization. It’s a securitization of securitizations.

I’m not “for” or “against” index funds. I’m “for” the intentional use of index funds to access broad market returns (a.k.a “beta”) in a cheap and tax-efficient manner, particularly for small, unsophisticated investors who would rather get on with their lives than read lengthy meditations on the nature of financial markets. I’m “against” the idea that index funds are always and everywhere the superior choice for a portfolio.

Likewise, I’m not “for” or “against” traditional discretionary management. I’m “for” the intentional use of traditional discretionary (or systematic quant) strategies to access specific sources of investment return that can’t be accessed with low cost index funds. I’m “against” the idea that traditional discretionary (or systematic quant) strategies are always and everywhere the superior choice for a portfolio.

What sources of return are better accessed with discretionary or quant strategies?

That’s a subject for another post.

Case Study: Integrating Fundamental & Technical Analysis To Trade Embraer

(Standard disclaimer applies here. This is not investment advice and it’s not a research report. Don’t blindly follow or believe anything you read on this blog. I could be making all of this up. This is written for informational and entertainment purposes only.)

ERJ_Chart_Annotated — Annotated ERJ chart with technical indicators. Sources: Morningstar Direct & demonetized account records

This is a follow up to my technical analysis post. In it I will discuss how technical indicators informed my decision to trade shares of Embraer (ERJ). As of 01/17/18, I had earned a 66% IRR on my ERJ trade versus what would have been a 35% cash return from buying and holding the shares. I don’t say this to claim I am the world’s greatest investor or trader. I promise you I am not. I am merely writing to illustrate my thought process and why I believe there are real dollar benefits to looking at the world through both fundamental and technical lenses.

I am an investor first and a trader second (if at all). I seek out long-term investments and will only trade them actively if the following conditions are met:

High confidence in my estimate of the business’s intrinsic value. For ERJ, by playing around with the numbers in a discounted cash flow model I estimated the stock was worth $25-$30/share at time of purchase and could be held for the long term based on a competitive moat and full-cycle returns on capital. For me, intrinsic value serves as the anchor for any trading activity. The less confident I am in my valuation, the less likely I am to trade.
The stock is liquid enough to trade actively. I invest in small caps and even micro caps at times. Even my very small orders can move the market for those securities. If my market impact will be significant I would rather not trade as transaction costs (namely the bid-ask spread) will weigh heavily on returns.
High confidence the stock price is misaligned with intrinsic value, and that the misalignment will correct or over-correct in time. Usually this means there is some element of cyclicality in play, but it can also be the product of non-fundamental buying and selling.

ERJ met all of these criteria.

It is worth mentioning I have a clear idea of what I am trying to achieve when I actively trade a stock: I am looking to improve the IRR on the position versus what I would earn as a buy-and-hold, cash return. I don’t typically trade fully in and out of positions. Rather, I dynamically overweight and underweight positions over time. This is my preferred strategy for investing in well-run, cyclical businesses (poorly run cyclical businesses go bankrupt so are dangerous to own without solid stressed/distressed investing chops).

Embraer’s (Abridged) Fundamental Story

ERJ is a Brazilian aerospace manufacturer. Despite being domiciled in Brazil, most of its revenue is earned abroad, specifically from its North American commercial aviation business, which competes with Bombardier. ERJ also manufactures executive jets and military aircraft. The bulk of today’s revenue and operating profit lie in the commercial aviation business.

ERJ is nearing the end of an investment cycle for the next generation of its successful E-Series jets. Major capex programs create business uncertainty, as well as a near-term drag on financial results, and this is what created the opportunity in ERJ shares. I believe my initial estimate of ERJ’s intrinsic value was higher than the market’s because the market had underestimated the probability of success for the E-2 Series program, and was undervaluing the optionality of the defense and executive jet businesses.

Trading ERJ

I was very lucky with my entry point. I always say I would rather be lucky than good. Money earned from luck spends the same as money earned from skill. And anyway no one looking at your returns can tell the difference.

As ERJ’s price approached $24 it was also approaching the lower end of my valuation range ($25-$30). However, the fundamentals of the business hadn’t really changed. Nor had the uncertainty inherent in the E-2 Series program been resolved in a significant way. And with 2018 set to be a “transition” year for the business as the first E-190 jets rolled out to customers, it was very possible a temporary setback such as a weak quarter or E-2 development delay could easily send the shares much, much lower. Given the deteriorating risk/reward ratio, this seemed like a great opportunity to trim the position and lock in some gains. $24 coincided with a resistance level for the stock (though honestly I didn’t draw the lines when I placed the trade). Around this time the money flow index was also indicating the stock was overbought.

Again, I was lucky in my timing. I waited patiently for ERJ to fall to its established support level of ~$19.50 and rebuilt the position. The stock traded sideways until late December, when ERJ and Boeing confirmed they were engaged in merger talks. I will not bore you with the details but I felt there was a high probability the talks would end with no deal or at best some kind of joint venture agreement due to a veto right held by the Brazilian government related to ERJ’s defense business. During this time, the prior resistance level of $24 turned into the new support level.

That makes intuitive sense. No chart pattern voodoo is required. Previously, $24/share had been on the high end of fundamental investors’ estimates of the stock’s value. Now that ERJ’s fundamentals had inflected positively, it would make sense for that price to become the low end of a new range.

A couple of weeks after the original announcement a news story broke that Boeing had offered $28/share for a full takeover. $28 happened to lie smack in the middle of my $25-$30 valuation range. This was a critical piece of information because it implied the risk/reward tradeoff had deteriorated significantly. There was probably 1:1 upside to downside in the position at best. I trimmed heavily at a little over $26 and still hold a small position. If a deal gets done I will make a little more money on the takeout. If a deal doesn’t get done I will have an opportunity to rebuild the position at a lower level having gained additional conviction in my fundamental investment thesis.

Takeaways

This case study illustrates my view of active trading: it is a tool for managing the risk/reward tradeoffs embedded in a portfolio. Personally, I want to overweight positions when the risk/reward tradeoff is good and underweight them when it deteriorates. What I do not want to do is make binary decisions (e.g. choosing between “fully invested” and “100% cash”). In my opinion, there is too much randomness and uncertainty in the world and in markets to make blanket, binary calls about position sizing. See the chart below for a stylized example.

intrinsic_value_vs_market_price — Source: Unknown (found via Google Image Search)

A good business will steadily compound its intrinsic value over time (red line). However, there are times when market price overshoots or undershoots intrinsic value (black line). In this way, having the ability to trade at the market price is kind of like owning an option struck at the intrinsic value per share. When a stock is overvalued the ability to trade functions like a put option (you can sell the stock for more than it is really worth). When a stock is undervalued the ability to trade is like a call option (you can buy the stock for less than it is really worth). The cost of the option is your transaction costs (commissions, bid-ask spread, taxes).

Put more simply: active trading allows you to overweight risk when you are getting paid well for taking it and to underweight risk when markets get stingy. However, using this approach, it is absolutely critical to have a high confidence estimate of intrinsic value. Otherwise you risk burning up capital as you chase the price around, getting whipsawed by reversals as you go.

Technically…

18117_JBLU_Technicals — Source: Morningstar Direct

Given how many smart people end up working in investment management, I am always surprised how siloed we can be. You tend to be a fundamental guy, OR a quant gal, OR a technician. Never all three. In my view there ought to be more interdisciplinary investment strategies. One reason there aren’t more of them is that capital allocators have a hard time underwriting strategies that don’t fit neatly into pre-established boxes (a subject for another post).

Personally, I don’t believe our world breaks down into neat little boxes, so I am interested in opportunities to integrate analytical techniques from different disciplines. To that end I have been studying up on how you might marry fundamental and technical analysis in a disciplined way. Typically a vast chasm of prejudice separates the two camps.

Fundamental Analyst:“Intrinsic value is what matters. Market price fluctuations are just noise to be ignored. Analyzing charts is like tossing chicken bones and reading the entrails of livestock to see the future. It is like trading based on ancient superstition.”

Technician:“Market prices are what matter. Market prices reflect supply and demand dynamics, as well as investor psychology. Prices are real and tangible, unlike some academic’s estimate of intrinsic value, which depends on “squishy” estimates of growth rates and discount rates.”

What we have here are two people talking across each other. It is like two people arguing over whether hammers or screwdrivers are “better” tools. In reality hammers and screwdrivers are different tools with different use cases.

I don’t believe technical analysis is particularly useful over long time horizons. There is plenty of evidence that in the long run, stock prices track earnings and dividend growth. I also don’t believe fundamental analysis is particularly useful over short time periods. If you are placing a trade, it is supply and demand that impact your execution, not market price relative to intrinsic value.

Fundamental analysis is going to give you a better idea of whether a business will be a good investment for the next decade. Technical analysis is going to give you a better idea of why today’s price is moving up or down.

Now, I should be up front about the fact that I am not at all interested in chart patterns. I have no interest in scouring candlestick charts for head-and-shoulders or cups-and-handles or van-gogh’s-remaining-ear. As far as I’m concerned that really is like tossing chicken bones or reading animal entrails. I prefer to use simple technical indicators to get a sense of price momentum and investor psychology.

For the time being at least I have focused on three indicators:

Support/Resistance Lines: You can draw a support line across the lows on a chart and a resistance line across the highs. In my view (I certainly don’t claim to be an authority on technical analysis), these lines are rough indications of where valuation sensitive investors have acted to counter a stock’s momentum. The support line forms where valuation sensitive investors step in to buy the stock. The resistance line forms where they sell the stock.

Moving Averages: Moving averages quantify short-term price trends versus long-term price trends and are useful for visualizing momentum. It is generally a bullish sign when a shorter-term moving average crosses above a longer-term moving average and a bearish sign when a shorter-term moving average crosses below a longer-term moving average.

Money Flow Index: The money flow index is an indicator tracking volume-weighted price momentum. It is an oscillator that moves between a range of values. It is useful for understanding whether price momentum is overextended in either direction, and whether it might soon reverse. More on the calculation and interpretation of money flow index here.

I think of the support/resistance lines as marking out the upper and lower bounds for the market’s estimate of a stock’s intrinsic value. Fundamental investors enforce these boundaries by trading contra-momentum (they sell when they believe a stock is overvalued and buy when they believe a stock is undervalued). Inside those boundaries, a stock will tend to ping-pong back and forth until the fundamentals change unexpectedly or fundamental investors significantly alter their expectations. A variation on the latter is when the type of investor dominating a stock’s investor base transitions from value to growth investors or vice versa.

Thus, I would argue, if you are an investor with a high degree of confidence in your estimate of a stock’s intrinsic value, and that estimate differs significantly from market expectations, you may be able to profitably trade around momentum-driven price swings–the goal being to generate higher position-level IRRs than you would earn by simply buying and holding.

In a follow on post I will walk through a live case study from my own portfolio to make this more concrete.