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.”

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.

Our World In Meta-Games

Matryoshka_Russian_politicians
Source: Brandt Luke Zorn via Wikipedia

The world is a complicated place. A good way of attacking that complexity is to view the world as a nested series of games and meta-games.

Ben Hunt at Epsilon Theory wrote an excellent post about meta-games in financial markets a while back, specifically in the context of financial innovation. While I’m going to take a slightly different angle here, his illustration of how a meta-game works is useful as a jumping off point.

It involves the coyotes that “skirmish” with the residents of his town:

What’s the meta-game? It’s the game of games. It’s the larger social game where this little game of aggression and dominance with my wife played out. The meta-game for coyotes is how to stay alive in pockets of dense woods while surrounded by increasingly domesticated humans who are increasingly fearful of anything and everything that is actually untamed and natural. A strategy of Skirmish and scheming feints and counter-feints is something that coyotes are really good at. They will “win” every time they play this individual mini-game with domesticated dogs and domesticated humans shaking coffee cans half-filled with coins. But it is a suicidal strategy for the meta-game. As in literally suicidal. As in you will be killed by the animal control officer who HATES the idea of taking you out but is REQUIRED to do it because there’s an angry posse of families who just moved into town from the city and are AGHAST at the notion that they share these woods with creatures that actually have fangs and claws.

For simplicity’s sake, I’m going to write about four interrelated layers of “games” that influence financial markets. Imagine we are looking at a set of Russian nesting dolls, like the ones in the image at top, and we are working from the innermost layer out. Each successive layer is more expansive and subsumes all the preceding layers.

The layers/ games are:

1. The Security Selection Game

2. The Asset Allocation Game

3. The Economic Policy Game

4. The Socio-Political Power Game

Each of these games is connected to the others through various linkages and feedback loops.

Security Selection

This is the most straightforward, and, in many ways, the most banal of the games we play involving financial markets. It’s the game stock pickers play, and really the game anyone who is buying and selling assets based on price fluctuations or deviations from estimates of intrinsic value is playing. This is ultimately just an exercise in buying low and selling high, though you can dress it up any way you like.

While it often looks a lot like speculation and gambling, there is a real purpose to all this: price discovery and liquidity provision. The Security Selection Game greases the wheels of the market machine. However, it’s the least consequential of the games we will discuss in this post.

Asset Allocation

Asset Allocation is the game individuals, institutions and their financial advisors play as they endeavor to preserve and grow wealth over time. People often confuse the Security Selection Game with the Asset Allocation Game. Index funds and ETFs haven’t helped this confusion, since they are more or less securitizations of broad asset classes.

At its core, the Asset Allocation Game is about matching assets and liabilities. This is true whether you are an individual investor or a pension plan or an endowment. Personally, I think individual investors would be better served if they were taught to understand how saving and investing converts their human capital to financial capital, and how financial capital is then allocated to fund future liabilities (retirement, charitable bequests, etc). Unfortunately, no one has the patience for this.

The Asset Allocation Game is incredibly influential because it drives relative valuations across asset classes. As in Ben Hunt’s coyote example, you can simultaneously win at Security Selection and lose at Asset Allocation. For example, you can be overly concentrated in the “best” stock in a sector that crashes, blowing up the asset side of your balance sheet and leaving you with a large underfunded liability.

I sometimes meet people who claim they don’t think about asset allocation at all. They just pick stocks or invest in a couple of private businesses or rental properties or whatever. To which I say: show me a portfolio, or a breakout of your net worth, and I’ll show you an asset allocation.

Like it or not, we’re all playing the Asset Allocation Game.

Economic Policy

The Economic Policy Game is played by politicians, bureaucrats, business leaders and anyone else with sociopolitical power. The goal of the Economic Policy Game is to engineer what they deem to be favorable economic outcomes. Importantly, these may or may not be “optimal” outcomes for a society as a whole.

If you are lucky, the people in power will do their best to think about optimal outcomes for society as a whole. Plenty of people would disagree with me, but I think generally the United States has been run this way. If you are unlucky, however, you’ll get people in power who are preoccupied with unproductive (yet lucrative) pursuits like looting the economy (see China, Russia, Venezuela).

The Economic Policy Game shapes the starting conditions for the Asset Allocation Game. For example, if central banks hold short-term interest rates near or below zero, that impacts everyone’s risk preferences. What we saw all over the world post-financial crisis was a “reach for yield.” Everyone with liabilities to fund had to invest in progressively riskier assets to earn any kind of return. Cash moved to corporate bonds; corporate bonds moved to high yield; high yield moved to public equity; public equity moved to private equity and venture capital. Turtles all the way down.

A more extreme example would be a country like Zimbabwe. Under Robert Mugabe the folks playing the Economic Policy Game triggered hyperinflation. In a highly inflationary environment, Asset Allocators favor real assets (preferably ones difficult for the state to confiscate). Think gold, Bitcoins and hard commodities.

This is no different than Darwin’s finches evolving in response to their environment.

Do you suppose massive, cash-incinerating companies like Uber and Tesla can somehow exist independent of their environment? No. In fact, they are products of their environment. Where would Tesla and Uber be without all kinds of long duration capital sloshing around in the retirement accounts and pension funds and sovereign wealth funds and Softbank Vision Funds of the world, desperate to eke out a couple hundred basis points of alpha?

Insolvent is where Uber and Tesla would be.

In general, western Economic Policy players want to promote asset price inflation while limiting other forms of inflation. There are both good and selfish reasons for this. The best and simultaneously most selfish reason is that, to a point, these conditions support social, political and economic stability.

However, the compound interest math also means this strategy favors capital over labor. This can create friction in society over real or perceived inequality (it doesn’t really matter which–perception is reality in the end). We’re seeing this now with the rise of populism in the developed world.

The Sociopolitical Power Game

Only the winners of the Sociopolitical Power Game get to play the Economic Policy Game. In that sense it is the most important game of all. If you are American, and naïve, you might think this is about winning elections. Sure, that is part of the game. But it’s only the tip of the proverbial iceberg.

This game really hinges on creating and controlling the narratives that shape individuals’ opinions and identities. If you are lucky as a society, the winners will create narratives that resemble empirical reality, which will lead to “progress.” But narratives aren’t required to even faintly resemble reality to be effective (it took me a long time to understand and come to grips with this).

You could not find a more perfect example of this than President Donald Trump. People who insist on “fact checking” him entirely miss the point. Donald Trump and his political base are impervious to facts, precisely because Trump is a master of creating and controlling narratives.

Ben Hunt, who writes extensively about narrative on Epsilon Theory, calls this “controlling his cartoon.” As long as there are people who find Trump’s narratives attractive, he will have their support. Facts are irrelevant. They bought the cartoon. (“I just like him,” people say)

It’s the same with Anti-Vaxxers. Scientific evidence doesn’t mean a thing to Anti-Vaxxers. If they cared even the slightest bit about scientific evidence, they wouldn’t exist in the first place!

I’m picking on Trump here because he is a particularly prominent example. The same can be said of any politician or influential figure. Barack Obama. Angela Merkel. JFK. MLK. I think MLK in particular is one of the more underrated strategists of the modern era.

Here is Sean McElwee, creator of #AbolishICE, commenting to the FT on effectively crafting and propagating narratives:

“You make maximalist demands that are rooted in a clear moral vision and you continue to make those demands until those demands are met,” said Mr McElwee. “This is an issue where activists have done a very good job of moving the discussion of what has to be done on immigration to the left very quickly.”

If you want to get very good at the Sociopolitical Power Game, you have to be willing to manipulate others at the expense of the Truth. It comes with the territory. Very often the Truth is not politically expedient, because our world is full of unpleasant tradeoffs, and people would prefer not to think about them.

I have been picking on the left a lot lately so I’ll pick on free market fundamentalists here instead. In general it is not a good idea to highlight certain features of the capitalist system to the voting public. Creative destruction, for example. In Truth, creative destruction is vital to economic growth. It ensures capital and labor are reallocated from dying enterprises to flourishing enterprises. Creative destruction performs the same function wildfires perform in nature. Good luck explaining that to the voters whose changing industries and obsolete jobs have been destroyed.

Because of all this, many people who are very good at the Sociopolitical Power Game are not actually “the face” of political movements. These are political operatives like Roger Stone and Lee Atwater, and they are more influential than you might think.

The Most Important Thing

There is a popular movement these days to get back to Enlightenment principles and the pursuit of philosophical Truth. I’m sympathetic to that movement. But I’m not sure it really helps you understand the world as it is.

In the world as it is, people don’t make decisions based on Truth with a capital T. In general, people make decisions based on: 1) how they self-identify; and 2) what will benefit them personally. Rationalization takes care of the rest.

When have you heard an unemployed manufacturing worker say, “yeah, it’s a bummer to be out of a job but in the long run the aggregate gains from trade will outweigh losses like my job”?

In the world as it is, people operate much more like players on competing “teams.” They want their team (a.k.a tribe) to win. They are not particularly concerned with reaching stable equilibria across a number of games.

And that tribal competition game is probably the most important meta-game of all.

Book Review: Every Shot Must Have A Purpose

every_shot_must_have_a_purposeGolf is a weird game. Playing well is actually fairly demanding physically (assuming you are walking). It requires core strength and good hand-eye coordination. But what makes golf truly weird is the mental dimension. Sure, all sports have a mental dimension. But golf is especially mental. If your head is not right, you will play terribly.

Every Shot Must Have A Purpose, by Pia Nilsson and Lynn Marriott, is described early on as “a life philosophy, not merely a golf instruction book.” It is therefore relevant for anyone engaged in any complex and mentally demanding endeavor (read: investing). Given the nature of this blog, I’m going to focus on the broader relevance of the ideas in the book.

Summary

There are a handful  of Big Ideas in this book:

  • Focus on process, not outcome
  • Learn to bring yourself from heightened emotional states back to neutral
  • Trust your swing. It is your signature.

All of this is relevant for investors. Even the part about trusting your swing. I’ll take them in reverse order.

Trust Your Swing

On trusting your swing, Nilsson and Marriott write:

If you can hit the shots you want under pressure, your swing is working. What is important is to make up your mind what swing you believe in, and to have the discipline not to abandon that belief because of a bad round or two. To be in “search-and-scan” mode never works over time. Find your swing, trust it, and stay committed to it.

For the investor, your “swing” is your investing discipline. It is the value creation mechanism(s) that will compound the value of your capital over time.

Classical Ben Graham value investing is a swing form. Munger and Buffett-style value investing is a swing form. Momentum investing is a swing form. All of these swing forms “work” because they are fundamentally sound in terms of economic principles and investor behavior. Just like the golf swing “works” because it is grounded in the laws of physics.

What does not work very well is trying to time different styles to chase “what’s working” at a given point in time. This is the equivalent of trying to rebuild your golf swing from scratch after every round where you score poorly. Both are a recipe for poor future performance.

Bring Yourself Back To Neutral

It is fun to take a pitching wedge from 90 yards out and land a perfect strike six feet from the pin. When you hit a shot like that, you literally get high. But when you chunk a five iron thirty-five yards from a perfect lie in the middle of the fairway, you crash.

Experiencing wild emotional swings is not a recipe for consistent golf.

Likewise in investing, you get high when a stock doubles in three months. You crash when a name halves on some seemingly random exogenous event.

How many times have you hit your tee shot into the trees and then, in a fit of anger, tried to do too much with your second shot and ended up making a triple bogey? The disappointment with the drive leads you to attempt to erase the poor shot with one swing. And we all know how that works out. More often than not, a gamble is greeted with a ball clunking off a tree or remaining in the rough.

The frustrating thing is that on many of those occasions, when you looked back at the round you wondered why you didn’t just pitch back to the fairway and settle for a bogey–or maybe a one-putt par. Anger opens the door to a variety of mistakes: bad decisions, hesitant swings, rushed tempo, and even not seeing the line to the target clearly.

Consistent performance starts internally, with how you regulate your emotions. The goal isn’t to become a robot impervious to emotion. I don’t think such a thing is possible. And even if it is, it’s certainly not healthy. The goal is that whether you hit a good shot or a bad shot (whether an investment is a winner or a loser) you are able to bring yourself back to a neutral state of focus, where your attention is on executing the shot in front of you.

Focus On Process, Not Outcome

One of the reasons golfers–professionals as well as recreational players–can’t take their games from the range to the course is that, in the current practice culture, they are two different experiences. Just as we try to unify the mental with the mechanical aspects of the game, we also must try to erase the line between practice and playing. We want to teach you to play when you practice and practice when you play. In the end, it all has to be about executing golf shots with total commitment when it matters most. To do this you have to learn that playing needs to be a process focus and not score focus.

It’s not that different in investing. Particularly in situations where you have to make a buy/sell/hold decision under pressure. Thinking about the score (returns) doesn’t do any good here. If anything, you’ll fall victim to the disposition effect.

Who Should Read This Book

Anyone trying to improve her golf game should read this book. Investors and other professionals who golf (regardless of skill level–I think I am a 25 handicap) can also benefit from applying these concepts to areas outside the game. I would not recommend the book to non-golfers, as it’s hard to relate if you haven’t struggled through learning the game or fought through some difficult rounds.

Betting Dark Side

In craps the best bet on the table (other than Odds) is Don’t Pass. The house edge is just a teensy bit narrower there than on the Pass Line. But no one really bets that way. And when people do, they are quiet about it, because they are betting for everyone else at the table to lose. That’s not the way you endear yourself to a bunch of degenerates at the casino. Betting Don’t Pass is also called betting “dark side.”

Personally, I have no interest in betting dark side in craps. The edge is pretty small to have to endure swarthy drunks shooting you sideways glances all night. But when it comes to investing I am plenty interested in opportunities to bet dark side.

In fact, sometimes I play a mental little game with myself called: What’s A Seemingly Obvious Trend Or Theme I Can Get On The Other Side Of?

For example right now everyone in the US is whining about how there are no cheap stocks. You know where stocks are cheap?

Russia.

In Russia you’ve got stuff on single digit earnings multiples paying 6% dividend yields. And it’s not even distressed stuff for the most part. Research Affiliates has got a phenomenal little asset allocation tool you can use for free. See those two red dots on the upper right in the double-digit return zone? That’s Russian and Turkish equities. (In case you are wondering, US large cap equity plots at about 40 bps of annualized real return)

RAFI_Cap_Markets201806
Source: Research Affiliates; Returns pictured are estimated real returns

Yeah. I know. Everyone hates Russia. You can probably rattle off at least five reasons why Russia is an absolute no-go off the top of your head. But I will happily bet dark side on Russian equity. I won’t bet the farm, but I’ll take meaningful exposure. The reason is I am getting paid pretty well to take Russian equity risk.

Risk assets are a pretty crappy deal here in the US. (40 bps real per year over the next decade, remember?) Here everyone’s convinced themselves stocks don’t go down anymore so they are willing to pay up. I guess some day that will be put to the test. We’ll see.

In the meantime, what other trends can we get on the other side of?

ESG might create opportunities. If you haven’t heard of ESG it stands for Environmental, Social and Governance. Big asset managers have become obsessed with ESG because it’s an opportunity to gather assets from millennials and women at a time when index funds and quants are hoovering up all the flows.

This is literally what the big asset managers tell allocators in presentations now: “millenials and women are going to inherit all the assets and they want to be invested in line with their values. Here are all our ESG products. Also here is marketing collateral to help you have ‘the ESG talk’ with your clients.”

So where do we go from here?

Well, for starters I am thinking a trillion dollars rotates into stuff that screens well on ESG. If this persists long enough and to a significant enough degree the stuff that doesn’t screen well on ESG is going to get hammered. With any luck it will get kicked out of indices and analysts will drop coverage and the bid-offer spreads will blow out.

Like Russian equities, the oil companies and the natural gas companies and the miners and the basic chemical companies and the capital intensive heavy manufacturers will trade on single digit earnings multiples with 6% dividend yields. All because they don’t score well on the asset gatherers’ screens.

So yeah, I think I’ll bet dark side when it comes to ESG, too.

For the record, I don’t have anything against ESG in principle. I am actually a big fan of  an extreme form of ESG, called impact investing, where you allocate capital with low return hurdles (like 0% real) to achieve a specific social objective. Maybe to fund development in a low income community in your city. Micro-lending is an example of this, and I think it’s a better model than philanthropy in many cases. But that’s a topic for another day.

This post is about how people’s emotional reactions to the securities they own create bargains. Here betting dark side is betting on something kind of icky. “Ick” is an emotional reaction. When people react emotionally to stuff, it has the potential to get mispriced. “Ick” is a feeling that encourages indiscriminate selling.

That’s where the Don’t Pass bet comes back into play. It’s one of the better bets in the casino, and it’s massively underutilized. Why?

Because it makes people feel icky.