Wednesday, May 20, 2009

Asset Class Labels - Ari Paul

The traditional classification method looks at the asset itself (commodity, equity etc). Alpha’s method looks at the investor’s claim on the asset (real, fixed, residual, or derivative). Both are important to understand the nature of an investment. For example, physical ownership of crude oil behaves very similarly to a collateralized oil future, so the traditional method does a fine job. On the other hand, a derivative claim on real estate (like a highly leveraged CDO) behaves nothing like real ownership of real estate; Alpha’s investor claims method is much more accurate in this case.

I’d like to add yet a third dimension to classifying investments that will hopefully clarify rather than complicate. That third dimension is strategy. By “strategy” I’m not referring to the strategy of the fund or portfolio (e.g. long/short), but rather the reason for purchasing a specific asset. We can categorize the purchase of any asset as arbitrage, market making, value investing, growth investing, macro, or pattern. I’m using these terms a little differently than they are usually applied to portfolio strategies. Arbitrage is strictly zero risk trading (e.g. buying a contract on one exchange and selling an identical contract on another exchange at a higher price.). I’m using “market making” to refer to an asset purchase motivated by the belief that the price has been temporarily depressed by order flow (e.g. a customer faces a margin call and is forced to sell a stock to you). Value investing means purchasing an asset below its current intrinsic value. Growth investing is purchasing an asset as a bet that its intrinsic value will increase. Macro refers to betting on political factors like interest rate changes and other systemic factors. “Pattern” refers to any kind of quantitative trading whether based on mean reversion or trend following.

This third dimension is sometimes the most revealing about the risks and expected returns from an investment. For example, if you learn that a class of hedge funds are facing investor redemptions and must liquidate their portfolios, you may buy many classes of assets and investor claims from them in the belief that prices are temporarily depressed from the forced selling (market making). This strategy may be coupled with fundamental analysis that the assets are undervalued (“value investing”). The same analysis and many similar pitfalls apply whether you are buying equity derivatives or physical silver from the distressed sellers.

I think each classification method adds value, and there’s no reason to limit ourselves to just one. As an investor, I evaluate any purchase by all these criteria. We should ask the same of anyone managing our money. What type of assets are they buying? What claim to those assets do they have? Finally, why are they buying those assets? Together, the answers to these questions can help us answer the real question: what is our expected return and what are our risks?

Tuesday, May 19, 2009

Asset classes and the inadequacy of labels - Alpha

Labels and bad jargon can lead to cloudy thinking and poor investing. Or as Orwell wrote: “the slovenliness of our language makes it easier for us to have foolish thoughts.” The institutional investment world, by consensus, labels asset classes such:

-Absolute Return
-Fixed Income
-Equities
-Private Equity
-Real Assets (Real estate and commodities)
See the investment report for the Yale Endowment and its chief Dave Swensen’s book “Pioneering Portfolio Management.”

I posit that the traditional scheme of labels is an unhelpful way to view the investible universe. A better way would be to look at the economic and legal structure of investments, and draw out broader, more conceptual categories. Basically, there are four types of claims: real, fixed, residual, and derivative. All stocks, bonds, absolute return strategies, and other financial instruments can be viewed as being in these buckets.

Real claims: This is direct ownership of, and often physical possession of, tangible assets. This means owning hard assets like gold, land, oil fields, oil barrels, wheat, etc. Most homeowners have a real claim on their home; they both own it and reside in it. Physical ownership and control is important for unstable societies (e.g. owning oil fields, pipelines, and ports in Nigeria, with one’s own security forces to guard these assets since the government and police are weak and unhelpful). Value comes from using up an asset: selling the land, drilling for oil and depleting the field, etc.

Fixed claims: This is a fixed monetary claim on the earnings of an asset or entity. Bonds are fixed legal claims against a company or government entity’s earnings or balance sheet. The debtor must pay a certain amount (interest) periodically to the creditor, and when the period is over the whole sum (principal) must be returned. Sometimes fixed assets are secured with real assets, sometimes not. When owning fixed assets, a strong legal framework and rule of law is important. If a creditor can’t trust the court system to collect from a defaulted debtor, this asset class becomes much riskier. Very safe real estate that pays out a steady annual income falls between a real claim and a fixed claim.

Residual claims: This is a residual monetary claim on the earnings of an asset or entity, coupled with some sort of ownership of the asset or entity. Often residual claims are in common stock or partnership interests. Preferred stock and convertible bonds are hybrids between fixed and residual claims. The distinction between public equities and private equity both is and isn’t important (we call that a paradox). Public equity owners have little control over a firm’s residual resources, a small ownership stake, and a liquid market for their stake. A private equity owner has much control over a firm’s residual resources, a large ownership stake, and an illiquid market for their stake.

Derivative claims: This is a structured contractual claim whose payout depends on the price or level of another “reference” entity from point 0 to point 1 in time. Futures, options, and structured products are derivatives, and the underlying reference entity can be real assets like gold, bonds, stocks, interest rates, commodities, indexes, and pretty much anything (weather, political outcomes, catastrophes, etc.). This is raw betting, sometimes hedging.

My thesis is that an investor must have a different skill set for each of the asset classes above.

For real claims, the productive or final sale value of the asset is key. At the purest, non-speculative level, investors in real assets are like 19th century entrepreneurs, attempting to turn land into cities, forests into timber products, and deserts into productive oil fields. The premium skill set here is resource conversion. Can the real claim owner turn silk fibers into textiles people want, or trees into furniture?

For fixed claims, coverage and security are key. That is, does an entity have the earnings to “cover” both the interest and principal payments? Analyzing the factors behind earnings, like profitability, firm size, return on assets, etc. is important. And as extra security, if the payouts are missed, can the fixed claim owner recover some value through secured real claims on hard assets? The premium skill set here on engineering analysis and character appraisal. What is the margin of safety on cash flow variation, and can the fixed claim owner trust the debtor to not default?

For residual claims, growth prospects and final payouts are key. Common stock holders want to know if they will ever get any of the residual cash generated by an entity. Of course, investors can sell their shares, but at some point, some final investor must get cash flows or a distribution of hard assets. Otherwise, the whole thing has been a sham, a game of musical chairs with no prize at the end. For a residual claim, there is no obligation for an owner to ever get anything. The premium skill set here is on economic analysis and character appraisal. What are the growth prospects for a business over time, and can the residual claim owner trust management to act in her best interest in distributing cash before doomsday? Value stock investors do more of a fixed claim analysis (is the stock trading for less than its assets?). Growth stock investors do more of a residual claim analysis (will enough cash be generated in the future to elevate the stock?). Distressed debt investors do a complicated mixture of fixed and residual claim analysis: fixed when they look at liquidation values and collateral; residual when they look at the worth of a business over time, and their potential future ownership share.

For derivative claims, a keen understanding of both the underlying security and the technical features of the derivative contract are key. To trade natural gas, one needs to understand the underlying supply and demand in the market (like a real claim owner), along with the quirks of the trading environment and the features of the contract (the roll date of the contract, its liquidity, etc.). Also, knowledge of a counterparty’s solvency is important, as a derivative claim owner could win on a trade and lose when the other side goes bust and fails to pay.

In the end, this classification scheme really gets to the heart of investing. In comparison to the conventional wisdom above, it combines “equities” and “private equity” into one class. It eliminates “absolute return,” which is a marketing buzzword that sells the idea that any investor or class can always be up and never down. And this scheme unmasks derivatives as their own world, a separate asset class which must be handled carefully or completely avoided.

One final note, which Vega points out:
“There's also the problem that the asset categories [describe above] can be manipulated: fixed claim investments can act as derivatives if they're at a deep enough discount and bought with leverage; then they effectively become call options. Investors in real estate in 2006 were more similar to equity speculators (looking to sell at a better price rather than collect any cash flow), than ‘19th century entrepreneurs.’”

Vega has a point. An equity position in a near-bankrupt company is more like a call option, a derivative claim. Likewise, distressed debt in an over-levered company is more like equity, a residual claim. For capital structure arbitrage, an investor is arbing the perceived relative value differential between a fixed claim and a residual claim (or fixed to fixed, fixed to derivative, etc.). A final example: when investors borrow much money to buy any hard asset, with the goal of flipping the assets months later, their position is more like a derivative claim than a real claim. The point is to look at the substance of a security/asset and its situation, not the outward label (bond, stock, real estate, etc.).

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.

Understanding Inflation - Alpha

I'm trying to figure out the very basic question, "What causes inflation?"

Three easy answers:

1) In a fiat money system, if the govt. just prints/creates more money at a rate much faster than economic growth.
2) A supply side shock, like the price of a super-central commodity like oil rising rapidly, which affects everything else.
3) A demand side shift, where people just want to consume more, but the number of goods is limited (so they deplete savings to chase after goods, causing prices to rise in the short-run).

The much more sophisticated answer can be found here:
Milton Friedman, Monetary Mischief (chapters 1-3).

Incidentally, I think we're far off from inflation. With the velocity of money so far down, the Fed can print as much money as its wants, but if people need to save and pay off debts (so output is below capacity), prices will stay low.

The best paper to read about the current debt deleveraging process is:
Irving Fisher, "The Debt Deflation Theory of Great Depressions" (1933)

Monday, May 4, 2009

Making Sense of Inflation -Ari Paul

I’d like to start a discussion about inflation; hopefully Alpha will join me in struggling with the myriad complexities of inflation and we can gain a deeper understanding.

First, it’s important to define what we mean by “inflation.” Economists generally define inflation as a persistent and broad increase in prices. By this definition, an increase in the prices of precious metals and crude oil does not represent inflation unless it’s accompanied by costlier consumer goods.

The greatest authority on inflation is probably Milton Friedman who famously wrote, “inflation is always and everywhere a monetary phenomenon.” Friedman argued that in the quantity theory of money, P = M*V/Q (price = quantity of money * velocity / quantity of goods produced), by far the most important part is the M (quantity of money). Friedman felt that the velocity of money and the quantity of goods produced were generally stable. He also felt that we can focus on just the supply of money since the demand for money is relatively stable.

Friedman argued that the quantity of goods produced and the demand for money are generally more stable than the supply of money, and therefore it is the supply of money (i.e. the central bank’s printing press) that is the cause of inflation. Friedman explained that as the newly printed money enters the economy, there is too much money chasing too few goods, so buyers bid up prices, producers then increase production by hiring more workers, which causes salaries to rise and creates an inflationary cycle. Anecdotally, Friedman noted it generally takes about 2 years from the date the central bank prints money until inflation is felt.

One problem with this simple model is that it relies on relatively fixed output capacity. If producers can quickly and easily increase output, prices won’t necessarily rise very much as demand increases. For example, many factories in China are currently running on just 1 shift a day. If demand for their goods increases, they don’t need to buy any new machinery or open a new facility, they can just stay open longer each day. Similarly, the large number of unemployed workers in China means that wages won’t need to rise very much for factories to add second and third shifts.

Another problem with Friedman’s supply driven model is that it neglects changes in the demand for money. While demand is usually stable, there are occasional turning points when the savings rate changes dramatically. From the end of 2007 until the beginning of 2009, the US personal savings rate rose from about 0% to over 4%. In other words, the demand for money increased quickly and dramatically.

I’ll try to lay out various ways of thinking about inflation over the next couple of posts and try to put them together into a framework with predictive power for our current circumstances.