Mortification of the Flesh

seventh-seal-the-1957-007-flagellants

Jöns: What’s that rubbish there?

Painter: People think the plague is a punishment from God. Crowds wander the land lashing each other to please the Lord.

Jöns: Lashing each other?

Painter: Yes, it’s a horrible sight. You feel like hiding when they pass.

Jöns: Give me a gin. I’ve had nothing but water. I feel as thirsty as a desert camel.

Painter: Scared after all?

The Seventh Seal

The Seventh Seal is a film about the silence of God. It’s set in medieval Europe, during the Plague and the Crusades. The protagonist, the knight Antonius Block, spends the film looking for signs of God’s existence. He stalls Death with a now-iconic game of chess.

They just don’t make ’em like this anymore, folks. We’re too clever for movies that take religion so seriously. So literally. It’s all too earnest for The Age of Snark.

Anyway, as much as it’s about Antonious Block’s existential crisis, The Seventh Seal is about medieval European society’s response to the apocalyptic destruction wrought by the plague. And boy, it ain’t pretty. Inquisitors burn witches. Charlatan theologians prey on the weak and the naive. Flagellants wander from town to town, putting on bizarre religious displays.

Observing a procession of flagellants, Block’s squire mutters:

Is this what we offer to modern men’s minds? Do they really believe we will take all of this seriously?

As investors, we too wrestle with God’s silence. It’s not war or plague that shakes our faith but changes in the structure and behavior of financial markets. How do we respond?

Inquisitors burn witches.

Charlatan theologians prey on the weak and the naive.

Flagellants put on bizarre religious displays.

In many circles–particularly those of the fundamental discretionary persuasion–there has emerged a kind of millenarian cult mindset. We endure this suffering to purge our sins. To mortify the flesh. When The Great Reckoning arrives, the Algos and the Indexers and the Risk Parity Heretics shall be cast into the flames. And we, The True Investors, shall emerge from the hellfire unblemished, as did Buffett after the Dot Com Bubble.

Make no mistake. This is religion. Yes, the sermon comes with charts. There will be CAPE charts. There will be Value/Growth dispersion charts. There will be Active/Passive cycle charts. But these charts aren’t science. They’re religious icons.

As we begin meeting with clients, investment managers and management teams in 2019, I’d encourage us all to look at the arguments and data we’re being presented though this lens.

How much of what’s passed off as “analysis” is, in fact, religious fanaticism clothed in the language and trappings of science?

How much of what’s passed off as “analysis” is, in fact, religious art?

How often, when we laud “conviction,” are we just promoting the mortification of the flesh?

Mental Model: Market Regimes

Markets and economies go through cycles. We’re used to hearing about bull markets and bear markets. We’re used to hearing about economic booms and recessions. But we don’t talk quite as much about market regimes.

A regime is a particular iteration of a particular phase (or phases) of a market cycle. Understanding regimes is important because markets are adaptive systems. Investors respond dynamically to changes in the economic environment, since changes in the economic environment influence their preferences for different cash flow profiles. As I wrote here, these changing preferences are key drivers for asset prices.

What characteristics define a regime? Things like:

  • Economic growth
  • Inflation
  • Interest rates (cost of capital)
  • Credit expansion/contraction
  • Market volatility

Every market regime is a bit different, but regimes tend to influence investor behavior in relatively predictable ways (partly the intuition behind the old saw: “history doesn’t repeat, but it rhymes”). In a deflationary regime, investors sell stocks and buy long-dated Treasury bonds. In an an inflationary regime, investors sell long-dated bonds, while bidding up real assets. In a growth regime, investors will bid up stocks at the expense of long-dated bonds.

Of course, this is a massive oversimplification. Identifying and profiting from market regimes is no easy feat. That’s the goal of the top-down global macro investor, and it’s an extraordinarily complex and difficult task.

So what do us mere mortals take away from this?

We want to ensure our financial plans and investment portfolios remain robust to different market regimes. This doesn’t mean we have to become market timers or macro forecasters. It means we should be thoughtful about the bets we’re embedding in our portfolios.

Unintended Bets

Today, the consensus view is that we’re in a “lower for longer” regime. Low growth. Low inflation. Low interest rates. There are big secular drivers behind this. In developed countries, older populations need to save a lot of money to fund future liabilities. Lots of investment capital in need of a home pushes down the cost of capital. Technological advances have kept a lid on inflation in many areas of daily life.

If the regime is “lower for longer,” what you want to bet on is duration.

We can define duration in different ways. Usually we’re talking bond math. In this context, duration is the sensitivity of a bond’s price to changes in interest rates. The longer a bond’s future cash flows extend out into the future, the higher its duration. The higher the duration, the more sensitive the bond will be to changes in interest rates. The archetypical high duration asset is the zero coupon bond.

If the market regime is “lower for longer,” you have an incentive to bet on large cash flows further out into the future. Low rates and low growth mean the opportunity cost for making these bets is also low.

Duration isn’t just a bond thing. Every asset with cash flows also has duration. It’s just harder to quantify for equities and real estate because of the other variables influencing their cash flow profiles.

Your venture capital investments? They’re a duration bet.

Your small cap biotechs? They’re a duration bet.

Your cash burning large cap growth equities? They’re a duration bet.

All these things are attractive in a “lower for longer” world because they offer Growth! But they’re also sensitive to the cost of capital. In a world of cheap capital, it’s easy to convince investors to subsidize losses for the sake of Growth! If and when the regime changes, that may no longer be the case.

As much as we hate to admit it, our portfolios are products of our environment. It’s what people are talking about when they say “don’t fight the market” and “don’t fight the Fed.” They might as well be saying, “don’t fight the market regime.”

As I’ve written many times before, I’m not a fan of “all-in,” “all-out” calls. That doesn’t just go for market timing. It goes for all the unintended bets that seep into our portfolios over time.

Especially those driven by market regimes.

Wunderwaffen, Part II

My last post was about tradeoffs we must weigh when building investment portfolios. There’s no such thing as a magical asset. Most of the time we spend looking for superweapons (Wunderwaffen) is wasted. In this post I want to riff on Wunderwaffen from another angle: our fascination with things that are exciting conceptually but prove ineffective or even dangerous in practice.

This is a Messerschmitt Me-163 “Komet”.

Messerschmitt Me 163B
Source: USAF

The Komet was a rocket-powered interceptor designed to combat Allied bombers over Germany. Its distinguishing feature was its incredible speed–it could climb to combat altitude in just three minutes. One test pilot hit a speed of 700 mph in 1944. This set an unofficial world record that wasn’t broken until 1947, when Chuck Yeager set another unofficial record during a secret test flight. Officially, the flight airspeed record remained below 700 mph until 1953.

Unfortunately, the Komet’s incredible engine power was also the source of its greatest weakness. The volatile fuel mixture that fed the engine made it the rough equivalent of a flying bomb. The wiki on the Komet provides these details:

The fuel system was particularly troublesome, as leaks incurred during hard landings easily caused fires and explosions. Metal fuel lines and fittings, which failed in unpredictable ways, were used as this was the best technology available. Both fuel and oxidizer were toxic and required extreme care when loading in the aircraft, yet there were occasions when Komets exploded on the tarmac from the propellants’ hypergolic nature. […]

The corrosive nature of the liquids, especially for the T-Stoff oxidizer, required special protective gear for the pilots. To help prevent explosions, the engine and the propellant storage and delivery systems were frequently and thoroughly hosed down and flushed with water run through the propellant tanks and the rocket engine’s propellant systems before and after flights, to clean out any remnants. The relative “closeness” to the pilot of some 120 litres (31.7 US gal) of the chemically active T-Stoff oxidizer, split between two auxiliary oxidizer tanks of equal volume to either side within the lower flanks of the cockpit area—besides the main oxidizer tank of some 1,040 litre (275 US gal) volume just behind the cockpit’s rear wall, could present a serious or even fatal hazard to a pilot in a fuel-caused mishap.

Ultimately, the Komet had no impact on the European air war. It made very few kills and to the extent it did, its kill ratio was low. This disappointing operational performance hardly justified the many pilot deaths that occurred in development, testing and training.

There are lots of Komet-like investment products out there, including:

  • Levered and inverse levered ETFs
  • VIX Futures ETPs
  • Naked option writing strategies

Most of us shouldn’t get anywhere near these products and strategies. I’ll make an allowance for my trader friends who have a deep and intuitive grasp of the market forces that shape changes in both realized and implied volatility. For us tourists, the leverage and short gamma exposure embedded in many of these products are every bit as dangerous as the Komet’s rocket fuel.

Here’s what an engine fire looks like for these strategies:

201812_SVXY_Chart
Source: Morningstar
201812_HFXAX_Chart
Source: Morningstar

So why are we drawn to this stuff?

Mostly because it’s cool. It’s got Sophistication! It gives us an excuse to talk about things like the volatility risk premium. It makes us feel as if we’re part of some elite fraternity of financial markets people. We “get it.” “Have fun with your index funds, you buy-and-hold simpletons.” 

Except really, the joke is on us.

We should never underestimate our deep-rooted weakness for Sophistication! Most of us got into this business at least partly because we’re smart and competitive. We’re captivated by that powerful rocket engine as a feat of human ingenuity. Deep down, we want a shot at that airspeed record.

But it’s not necessarily the most powerful, most sophisticated engine that’s going to win us the war. It might not even make a difference.

And if we’re not careful, it’ll blow up on us.

 

01/08/19 Addendum: Got into a Twitter discussion on this topic and Corey Hoffstein of Newfound Research was kind enough to educate me on how inverse and leveraged ETFs can be used in a DIY risk parity implementation for small investors. Here is the link to his article. So as always, it seems, #notall applies.

Wunderwaffen

One theme I harp on relentlessly is that there’s no such thing as a magical investment strategy. By “magical strategy” I mean some asset class or system that’s inherently superior to all others. Hedge funds were once sold this way, and we’ve spent the last 10 years or so watching the ridiculous mythology built up around hedge funds die a slow and miserable death.

The unpleasant truth is that all investment strategies involve tradeoffs. In this way, investment strategies are a bit like weapons systems.

Tank design, for example, must balance three fundamental factors:

  • Firepower
  • Protection
  • Mobility

This is a Tiger tank:

Bundesarchiv_Bild_101I-299-1805-16,_Nordfrankreich,_Panzer_VI_(Tiger_I).2
Source: Bundesarchiv via Wikipedia

You might recognize it from any number of WWII movies and video games. The Tiger is often presented as a kind of superweapon (German: Wunderwaffe)–an awe inspiring feat of German engineering. In many respects, the Tiger was indeed a fearsome weapons system. Its heavy frontal armor rendered it nearly invulnerable to threats approaching head-on. Its gun could knock out an American M4 at distance of over a mile, and a Soviet T-34 at a little under a mile.

The Tiger had its weaknesses, however, and they were almost laughably mundane. It was over-engineered, expensive to produce and difficult to recover when damaged. Early models in particular struggled mightily with reliability. The Tiger was also a gas guzzler–problematic for a German panzer corps chronically short on fuel.

Viewed holistically, the Tiger was hardly a magical weapon. The balance of its strengths and weaknesses favored localized, defensive operations. Not the worst thing in the world for an army largely on the defensive when the Tiger arrived on the battlefield. But it was hardly going to alter the strategic calculus for Germany. In fact, there’s an argument to be made that German industry should have abandoned Tiger production to concentrate on churning out Panzer IV tanks and StuG III assault guns. (Thankfully, for all our sakes, it did not)

Likewise with investment strategies, the tradeoffs between certain fundamental factors must be weighed in determining which strategies to pursue:

  • Alpha Generation
  • Liquidity
  • Capacity

Alpha generation is typically inversely related to liquidity and capacity. The more liquid and higher capacity a strategy, the less likely it is to consistently deliver significant alpha. Smaller, less liquid strategies may be able to generate more alpha, but can’t support large asset bases. Investment allocations, like military doctrine, should be designed to suit the resources and capabilities at hand.

If I’m allocating capital, one of the first things I should do is evaluate my strategy in the context of these three factors.

First, do I even need to pursue alpha?

If so, am I willing and able to accept the liquidity constraints that may be necessary to generate that alpha?

If so, does my strategy for capturing alpha have enough capacity for an allocation to meaningfully impact my overall portfolio?

In many cases, the answer to all three of those questions should be a resounding “no.”

And that’s okay! Not everyone should be concerned with capturing alpha. For many of us, simply harvesting beta(s) through liquid, high-capacity strategies should get the job done over time. Identifying strategies and investment organizations capable of sustainable alpha generation ex ante is extremely difficult. And even if we can correctly identify those strategies and investment organizations, we must have enough faith to stick with them through the inevitable rough patches. These are not trivial challenges.

But even more importantly, in a diversified portfolio it’s unlikely you’ll deploy a single strategy so powerful and reliable, and in such size, that it completely alters your strategic calculus. In general, we ought to spend more time reflecting on the strategic tradeoffs facing our portfolios, and less time scouring the earth for Wunderwaffen.

Storytime

GLENGARRY GLEN ROSS, Al Pacino, Jonathan Pryce, 1992, (c) New Line/courtesy Everett Collection

Ricky Roma: I’m going to tell you something. Your life is your own. You have a contract with your wife? You have certain things you do jointly? Bond there. And there are other things, and those things are yours. And you needn’t feel ashamed, you needn’t feel that you’re being untrue. Or that *she* would abandon you if she knew. This is *your* life.

Glengarry Glen Ross

Ricky Roma is the best salesman in the office. He’s at the top of the Cadillac board. And that’s no accident. Ricky Roma is a masterful storyteller. He knows all about needful things.

Ricky Roma’s stories appeal to us on an emotional level. But there are other, equally effective storytellers out there appealing to us on an intellectual level.

Much of what we think of as “financial analysis” is this second type of storytelling. Finance people tend to look down on writers and artists, but I can assure you there’s no less creativity involved in financial analysis. If you’ve ever built a discounted cash flow model, or an LBO model, you’re well aware of the enormous number of assumptions embedded in the things. Choosing a discount rate isn’t so different from a painter mixing colors on her palette.

Granted, that’s a fairly subtle example. Storytelling masquerading as analysis is much more obvious (not to mention silly) in the context of “portfolio update” and “strategy” meetings.

These are the meetings where a PM or strategist sits down with a slide deck and tells you about the state of a portfolio or the world. Make no mistake. There’s nothing analytical or scientific about this process. It’s theatre. The slide deck and the charts are just props to be used in the performance.

If the PM or strategist is a value guy, the story will be about mean reversion.

If the PM or strategist is a trend guy, the story will be about momentum.

The odds you’ll derive any decision-useful information from a performance like this are slim. To the extent there’s decision-useful information embedded in the performance, it’s in the metatext—the story of the story.

For example, there isn’t decision-useful insight embedded in a CE webinar about how floating rate securities have performed historically in rising rate environments. This is what I’d call a bagholder webinar. Same with sell-side research.

You don’t derive decision-useful insight from naively sitting through bagholder webinars and naively reading bagholder-oriented research. Do you honestly believe these firms produce research out of a deep, unwavering commitment to the Search For Truth?

No. Research groups are cost centers. They produce reports and exhibits in support of their salespeople. So always ask yourself: “why am I seeing this NOW?”

The first-order answer is usually that someone’s trying to sell you something. That firm hosting the CE webinar knows you know we’re in a rising rate environment. They know you’re worried about what it means for fixed income portfolios. Oh, look, they just happen to run a floating rate fund.

This may be a useful insight. But it’s also a trivial insight. Just because someone’s selling you something doesn’t mean it’s a bad deal.

More valuable insight comes from understanding the issuers of floating rate paper (via the sell-side) also know the firm running the floating rate strategy knows you’re worried about what rising rates mean for fixed income portfolios.

Put another way, what you need to address in your analysis isn’t how the asset class has performed historically. You need to address how the asset class might perform based on how deals are priced, structured and sold today.

Deal pricing is predominantly influenced by buy-side appetite for various types of securities. From there, it’s a matter of supply and demand.

The stories told by PMs and strategists and the sell-side and everyone else in the market ecosystem are told to influence our appetites for different cash flow profiles.

It’s storytelling that drives demand.

It’s storytelling that closes deals.

Remember this next time you’re parsing pro forma financial statements; or some chart illustrating the value/growth performance divergence; or a scatter plot showing how some asset class (*ahem* private equity) dominates everything else on a risk-adjusted basis.

It’s storytime.

The Best Risk Questionnaire (Bonus: It’s Free!)

Answer the following questions with complete honesty:

  • Did I buy equities in October and/or November of 2018?
  • If so, what did I buy?
  •  Why?

This exercise will give you a pretty good idea of how you handle market volatility. Not in a theoretical, highly-abstracted, mean-variance optimized way but in the visceral OH-MY-F*ING-GOD-this-stock-I-own-just-fell-40%-WTF-do-I-do-now?!?!? kind of way.

In other words, this exercise gets you thinking about risk in the only terms that matter.

Many people have told me, “oh when the market goes down stocks are on sale so I buy. Buffett says to be greedy when others are fearful.”

Most of them are liars.

People overstate their risk tolerance in bull markets. Ask the crypto people how much time they spent thinking about risk last December. Ask the FANG cheerleading section how much time it spent thinking about risk in 1Q18. I bet if you’d given these investors risk questionnaires they would’ve come back showing an extreme willingness to take financial risk. Everyone feels like Warren Buffett when the tape is printing big, fat green numbers day after day.

In the financial advice business we like to pretend we can put neat little numbers around people’s risk tolerance. We give them risk questionnaires or gussied-up, Millennial-friendly versions of risk questionnaires to match them with a model portfolio that ultimately ends up being the usual 80/20 or 60/40 or 70/30 mix you’d give someone just from eyeballing her age. Maybe we go 50/50 if she seems particularly elderly and infirm.

All of this is nonsense. It is scientism.

The way you measure someone’s true risk tolerance is to look at how they’ve allocated real dollars of their hard-earned cash. If a prospect shows up in your office with $500,000 in a bank savings account and no equity investments whatsoever, you’re dealing with someone who doesn’t like taking risk. If someone shows up with $1,000,000 of a $2,000,000 portfolio in small cap biotech stocks and another $500,000 in rental properties with a bunch of debt on them you know you’ve got a gunslinger on your hands.

Simple. Easy. Robust.

Yes, guy in the back, I can hear you muttering something under your breath about “investor education.” “Some of those people with $500k sitting at the bank just don’t understand investing and that’s why they sit in cash.” So what? Their willful ignorance further underscores their risk aversion.

People who are extremely tolerant of financial risk seek out risk on their own initiative. In business we call these people “entrepreneurs.” They may sometimes take risk in stupid ways, by reading scammy stock newsletters or buying a bunch of Litecoin or whatever, but their propensity for risk taking clearly manifests itself in their portfolios.

To steal blatantly from Taleb, this is a “skin in the game” thing.

Ignore what people say.

Pay close attention to what they do.

Needful Things

Satanic_Leland_Gaunt

Mr. Gaunt steepled his fingers under his chin. “Perhaps it isn’t even a book at all. Perhaps all the really special things I sell aren’t what they appear to be. Perhaps they are actually gray things with only one remarkable property—the ability to take shapes of those things which haunt the dreams of men and women.” He paused, then added thoughtfully: “Perhaps they are dreams themselves.”

–Stephen King, Needful Things

If your job is to sell people stuff, the path of least resistance goes something like this:

1)      Sell cheeseburgers to fat people

2)      Sell advice on giving up cheeseburgers to fat people

The point here isn’t to poke fun at fat people. The point is that “fat person” is an identity with a lot connotations attached to it. One might go so far as to call those connotations “baggage.”

Other identities with a lot of connotations attached to them include: “retiree,” “former executive,” “doctor,” and “little old lady who wants a good rate on her CDs.”

We’ve all got identities. We’ve all got baggage. We’ve all got cravings.

Salespeople know this.

I opened this with a quote from Stephen King’s novel. Needful Things. In the novel, Leland Gaunt sells trinkets. The trinkets take the form of something that matters to you. Whatever triggers your deepest desires and fears. And, of course, Leland Gaunt’s willing to give you a deal on that particular item. All he asks in return is a little favor…

You go into Leland Gaunt’s shop thinking you’ll shell out some cash for a trinket. A rare baseball card. A lampshade. A religious relic. But the true cost is your soul.

Investment products, too, are things that matter. They trigger powerful emotions. You come to associate them with your aspirations, hopes and dreams.

People who sell financial products know this. People who sell deals know this.

“Oh, so you’re a Little Old Lady Worried About The Market? We’ve got an equity indexed annuity for you.”

“Sophisticated allocator? I see private equity co-invests have caught your eye.”

“Tech entrepreneur? Have you ever looked at crossover biotech funds?”

The Leland Gaunts of the investment world traffic in symbols and memes:

Yield!

Diversification!

Innovation!

Security!

Sophistication!

Tax Breaks!

Deals!

I hate to break it to you purists, but most investments aren’t sold on the basis of future expected cash flows. Most deals are sold as little gray things that will satisfy whatever cravings you’ve got as a retiree or endowment CIO or little old lady looking for the best rate on a CD. Whatever matters to you, there’s a broker out there who will sell it to you.

And you’ll probably get a deal.

Caveat emptor.

 

(major h/t to Epsilon Theory for inspiring this post)

Mental Model: Value vs. Momentum

We’ve discussed at length how asset prices are driven by changes in investor preferences for different cash flow profiles. I’ve explored this both here and here. In this post, I suggest those preferences are grounded in two psychological profiles: mean reversion (value) and trend (momentum).

The psychology of mean reversion assumes all things revert toward long-run averages over time. Today’s winners will win a little less. Today’s losers will win a little more.

The psychology of trend assumes winners keep on winning, and losers keep on losing.

The more time I spend with investors and savers of varying sophistication levels, the more I believe people are hardwired for one or the other.

Personally, I’m hardwired for mean reversion. It’s extremely difficult for me to extrapolate strong growth, earnings, or profitability into the future. It’s painful–almost physically painful–for me to own popular stuff that’s consistently making new highs. If I happen to be winning in the markets, it invariably feels too good to be true.

A trend guy is just the opposite. Why own stuff that sucks? he asks. Stick with what’s working. It’ll probably get better over time. If anything, you should be shorting the losers.

A popular misconception about value and momentum guys is that value guys buy “cheap” stuff and momentum guys buy “expensive” stuff. I used to think this way. And I was wrong. For a long time I fixated on the headline valuation multiples of the stuff each personality owned, totally ignorant of what was going on under the hood.

The value guy says:

This security is pricing such-and-such a set of expectations, which reflect the naïve extrapolation of present conditions. This, too, shall pass. When expectations re-rate to properly reflect the characteristics of the underlying cash flow stream, I will exit at a profit.

The momentum guy says:

This security is pricing such-and-such a set of expectations, but those expectations aren’t high/low enough. When expectations re-rate to properly reflect the characteristics of the underlying cash flow stream, I will exit at a profit.

Of course, there’s another guy relevant to this discussion. That’s quant guy. Quant guy steps back and thinks, “gee, maybe all these mean reversion guys’ and trend guys’ psychological dispositions impact security prices in relatively predictable ways.” Quant guy decomposes the mechanics of value and momentum and builds systems for trading them. Quant guy catches a lot of flak at times, but I’ll say this for him: he tends to have a pretty clear-eyed view of how and why a given strategy works.

In closing, I want to suggest all fundamentally-oriented investment strategies, whether systematic or discretionary, are rooted in the psychology of value and momentum. Both have been shown to work over long periods of time. However, they don’t always (often?) work at the same time. Arguably, this inconsistency is directly responsible for their persistence.

Put another way: value and momentum tend to operate in regimes.

And regimes deserve a post all their own.

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.

Just Own Berkshire?

A friend asks:

Is the portfolio you own with shares of Berkshire Hathaway diversified enough to be your entire equity portfolio?

Here’s my response, with a bit of added color versus my original reply. It’s helpful to have Berkshire’s top 13F holdings (included below) for reference:

180930_BRK_13F
Source: Berkshire 13F via WhaleWisdom.com

Do I think you could buy today’s Berkshire 13F portfolio and hold it forever as a well-diversified portfolio? No. There’s no such thing as a permanent stock portfolio. Capital markets are far too dynamic for that.

What you’re really buying (and thus have to underwrite) with a share of Berkshire are Warren and Charlie’s capital allocation skills. This is an extremely concentrated portfolio. Not necessarily a bad thing for skilled investment managers like Warren and Charlie. But just a handful of stocks and their idiosyncratic characteristics are going to drive portfolio performance.

Do I believe you could plausibly own Berkshire and only Berkshire as a kind of closed-end fund/ETF managed by Warren and Charlie? Yes, I do. The obvious issue you run into here is that sooner or later Warren and Charlie are going to shuffle off this mortal coil. I suspect it’ll be much tougher for investors to maintain the same level of conviction in their successors.

Would I do it myself? No. It’s an awful lot of single manager risk to take, to just own Berkshire. Even if Warren and Charlie were immortal, it would be a lot of single manager risk to take. However, I could definitely see using Berkshire alongside just a couple other highly concentrated managers, if you’re the kind of investor who doesn’t mind high tracking error and is concerned more with the risk of permanent capital impairment than volatility.

Could you potentially just use Berkshire in place of an allocation to large cap US stocks? Yes, I definitely think you could.

The answer to this question really hinges on your definition of risk, and issues of path dependency in investment performance. In my view, the starting point for any asset allocation should be the global market capitalization weighted portfolio. Deviations from the global market capitalization weighted portfolio should be made thoughtfully, after careful deliberation. Whenever you deviate from the global market capitalization weighted portfolio, you are implicitly saying you’re smarter than the aggregated insights of every other market participant.

Sorry to say, but you’re probably not that smart. I’m probably not that smart, either.

To concentrate an investment portfolio in a single share of Berkshire implies you have a massively differentiated view of where value will accrue in the global equity markets, and that you’re extremely confident in that view. In hindsight, it seems obvious Berkshire would be a great bet. But in financial markets, literally everything seems obvious in hindsight.

Does this mean a concentrated bet on Berkshire wouldn’t work out?

Absolutely not. It just means we need to carefully consider whether a highly concentrated bet on Berkshire makes sense in light of its potential performance across a broad range of possible futures.

Personally, I’m not confident enough in my ex ante stock and manager selection abilities to bet the farm on a single pick like that.

And I think that’s true for most of us.