Wednesday, May 6, 2009

"I just pick stocks!" - Alpha

I have often heard many professional stock pickers, whether they be long-only managers or long/short managers, say:

“I just pick stocks. I don’t look at the economy or macro events. I’m just a bottom-up/long-only investor.”

I regard this as ignorance, investment malpractice, or both. After 2008, it’s a stubborn adherence to a failed mental model. Professional bond investors don’t succumb to this foolishness. They carefully track interest rates, inflation, GDP growth, taxes, and other macro variables closely, realizing that all these variables affect bond prices (and asset prices generally). As an example, a stock trading with a P/E of 10 is not cheap if govt. bonds are offering 15% yields (and both could be expensive if inflation goes from 2% to 30% in 6 months). While watching these variables closely, most investors are realistic about their predictive powers, which range from moderate (George Soros and Hugh Hendry) to nil (everyone else, especially professional economists).

What most “bottom-up” stock pickers don’t realize is that they have a macro assumption that they’re just not stating (it is so implicit they usually don’t even realize it). Their assumption is that the unprecedented US and world economic growth and equities boom from 1950 to 2007, including the long boom of 1981 to 2007, with minor crashes/recessions, will continue. The last part, 1981 to 2007, had moderate growth (1-5%) and low inflation (2-4%); it was perfect for nose-to-the-ground stock picking. Hence the macro view many long-only investors have is “progress will continue with minor blips.”

Bottom-up investors are ignoring the anomalies. Japan is in many ways worse off today than it was in 1989, and its equity and bond investors are certainly worse off (low yields and low earnings – stocks and bonds with low returns). This anemic environment could be the one that the US, UK, and other countries find themselves is for the next 5 years. Value, bottom-up investors were particularly strongly hit in 2008, as they didn’t see that all stock prices were inflated by late 2007 due to a worldwide credit and real asset (housing) boom. So when the crisis struck, these “buy-on-the-dip” types (a fabulous strategy from 1981 to 2000 and 2003 to 2007) ended up catching falling knives and axes; they were butchered. Investors like Warren Buffett, Bill Miller, John Scully, Mohnish Pabrai, and others were bloodied by their failure to closely consider the macro environment, its impact on different industries, and the final impact on the common stocks of companies they owned. The best bottom-up investors, like David Einhorn and Seth Klarman, were well-hedged; their low net exposures helped them minimize losses in 2008 and live to invest in another day.

A secular review of economies and markets suggest something different than never-ending economic and financial progress. Rather, a rise often ends with a decline, especially in the context of geographical relative wealth. Venice was the most prosperous European city in the late 13th century, the Dutch Republic took that role by the 16th century, Britain held it in the 19th century, and the US held the banner for the 20th century (some have theorized that the locus of power moves west). Argentina in 1919 was one of the world’s six richest countries, with valuable assets and a strong currency. A smart Argentine investor in 1919 would have borrowed to the hilt in Argentine pesos, invested in US stocks, and then would have closed out his worthless peso borrowings 10 years later in 1929 (or even better, gone short in May 1929 in both the US and Argentina). My point is that macro environments change, and bottom-up stock pickers can’t ignore what is happening at the top.

The underlying lesson is that too many stock pickers devote all their time to security selection, which is only one component out of three when investing. The other two components are asset allocation and market timing.

I. Asset allocation is the construction of a portfolio, intelligently balancing and diversifying assets, so that the sum is greater than the parts. This is both art and science. The science has been fairly delineated by modern portfolio theory, which has shown that all else equal, a portfolio should have uncorrelated or negatively correlated assets. The art is deciding the inputs: guessing at expected future returns, future variances, and future correlations, since all these variables change. Diversification is a sub-point. Holding 100 assets that are mostly or weakly correlated is much worse than holding two assets with a perfect negative correlation.

Asset allocation is closely tied to the risk/return preferences of the portfolio’s beneficiaries. Despite what investment advisors peddle, the vast majority of investors have only three goals: preserve wealth (rich people and endowments); save to pay out later (older workers and pension plans); and build wealth aggressively (younger workers and some rich people). A multitude of portfolios could meet each risk preference group, and the difficulty is that “safety” and “risk” change over time (GM bonds were once airtight, safe credits – today they are junk and risky distressed plays).

Asset allocation also involves picking geographies and asset types. As mentioned above, US equities won’t remain the best place for safety and growth forever. At some point, whether in 5 years or 50, another nation (China, India, Brazil, Australia, etc.) will eclipse the U S in growth, and investors should diversify accordingly. As for asset types, I will write about this in another post (my thought is that looking at stocks, bonds, real estate, oil, etc. is not helpful – these are false categories conceptually).

II. Market timing is trying to buy low and sell high – trading on emotions of greed and fear. George Soros and Mike Steindhardt acknowledge its importance, while Warren Buffett does not while he practices it surreptitiously. They are two ways to time markets:

1) Micro-timing: Darting in and out of assets every day, week, and month at what the trader believes are local maxima and minima. This is very difficult to do – experienced, full-time traders with an information edge can do this fairly well; it's dangerous for others.

2) Macro-timing: Adjusting the net exposure in one’s portfolio based on where one believes he/she is in the broader business and economic cycle. Hence, being net short in the last year of a boom, and heavily net long in periods of somberness and recession. To do this well, one needs to have traded/invested through at least two boom-bust sequences, studied a dozen or more, and never be carried away with the “this-time-is-different” euphoria. Or as Buffett puts it, one must “be fearful when others are greedy, and greedy when others are fearful.” It's difficult to do, especially because of the negative carry of being short near the top of a bubble (hedges cost money in good times), and the professional incentives to herd with foolish competitors for short-run quarterly numbers, even if they're jumping off the cliff thereafter.

I end with this thought: Long-only investors are the dodo birds of the investment jungle, waiting to be predated by their more adaptive counterparts. Smart bottom-up investors pay close attention to macro factors; the dumb and stubborn ones get eaten.

2 comments:

  1. Thanks. Well organized thought and well written.

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  2. Some other thoughts: It should have been mentioned that it is the primary responsibility of the individual investor to allocate assets in a responsible manner, e.g., see Meb Faber's site.
    A growth fund manager has a more narrow selection universe, and assumes that the end buyer (retail investor) is aware of this.
    They construct portfolios a bit differently than a small cap, but they all are aware of, and use some degree of correlated and non-correlated assets, or they would eventually implode, and or trail peer results.

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