Monday, July 13, 2009

Predicting the Future – Ari Paul

Trying to predict the future is usually a humbling if not embarrassing endeavor. Industry titans are often famously wrong in their areas of expertise (e.g. “640K [memory] ought to be enough for anybody” – Bill Gates 1981). Many top investors and traders simply give up trying. The father of value investing, Ben Graham, said he thought predicting future interest rates or which companies will grow faster than others, was so difficult as to be unworthy of the attempt. Most top traders seek to take advantage of brief inefficiencies or trends but avoid longer term “macroeconomic” bets. So, should we avoid speculating on the future altogether?

By “speculating on the future”, I mean trying to predict cultural, economic, or political conditions more than 3 years ahead of time. Will interest rates be higher or lower in 3 years? Which party will be in power? Will the world be in crisis or well into a new bull market? Many smart investors simply ignore these questions and focus on buying good companies at cheap prices, confident that this strategy will produce superior returns in the long run. From 1933 through 2007 in the USA, that strategy worked quite well, but there are two problems: 1. We can’t necessarily afford to wait a decade for the market to recover from severe recessions and 2. The strategy doesn’t work at all in indefinite bear markets in declining countries.(see Japan 1989-2009).

If we accept that predicting broad trends is at least useful if not absolutely necessary, what should we try to predict? Some areas of prediction are impossible while others are relatively easy. For example, I think it’s impossible to predict biomedical discoveries over the next decade; science and technology advances suddenly and unpredictably. Much easier to predict are demographics. We know how many 30 year olds live in the UK today, so we have a pretty good idea how many 40 year olds will be in the UK in a decade. Even here there are uncertainties; we have to estimate immigration and can always be surprised by a brutal war or plague. Still, demographic predictions are powerful and reliable. We know that Japan is headed for crisis as its population rapidly ages. The western world is in gradual decline as the number of consumers, workers, and taxpayers falls, and pensioners rise. China may face a crisis in 20 years as a result of its one child policy.

Similar to demographics, investment in infrastructure and human capital yields consistent dividends. For example, South Korea’s investment in education means they will have one of the most highly educated workforces in 10 years. Similarly, we can be sure that the Kenyan workforce won’t be filled with graduate degrees a few years after few Kenyans are attending college.

Wednesday, July 8, 2009

Scarlett O'Hara and Your Money - Alpha

One of the books I'm reading is Margaret Mitchell's excellent Gone with the Wind due to my partner's recommendation. Two great quotes on investing, from the two men who most influenced Scarlett, which are apt for today's environment:

Scarlett's father Gerald: "Land is the only thing in the world that amounts to anything... for 'tis the only thing in this world that lasts, and don't you be forgetting it! 'Tis the only thing worth working for, worth fighting for -- worth dying for." (38)

Scarlett's lover Rhett: "What most people don't seem to realize is that there is just as much money to be made out of the wreckage of a civilization as from the upbuilding of one." (193 - note that the context of the dialogue behind this quote is as sweet as the quote itself!).

More quotes to come as I find them...

Investing Lessons from the Madoff Fraud - Alpha

The Madoff fraud had many red flags, as reported to the blind SEC by a do-gooder citizen in 2005, but its lessons are broader.

-Do Your Own Work: In investing, always do your own due diligence, especially if you entrust your money to someone else. Don't rely on reputation or the referrals of others, no matter how sophisticated or disinterested the referring parties are. If you don't get transparency, avoid investing. You are the most vulnerable, psychologically speaking, when someone of a similar background to you (professional or educational background, wealth/social status, ethnic background) makes an unfounded recommendation. Especially don't rely on a government agency to do the diligence for you - often the regulators lock the barn door after the horses are long gone.

-Eggs in Many Baskets: Don't keep all your monies in one place, even if the place is a "gold standard" firm like Fidelity, Vanguard, Berkshire Hathaway, Renaissance's Medallion Fund, etc. Keep the bulk of your money in at least 2 or 3 firms/accounts and in multiple asset classes (the Talmud "recommends" stocks, bonds, real estate, and cash).

-Apply Common Sense/Street Smarts: If it sounds too good to be true, like the eerily positive and consistent returns Madoff reported, it probably is. Use your common sense and exit.

-Check the service professionals: are the auditors, custodians, lawyers, etc. large, independent, and reputable outfits? If your cash/asset balance is especially large (tens or hundreds of millions or more), don't even trust the investment firm's auditor. Go straight to firm's bank or custodian, speak to an executive, and look at their statements. Read the bank/custodian's financial statements and talk to its auditors. Make sure your portion of the bank's equity cushion is small, as the audit firm's insurance may not be able to pay you to recompensate you for fraud.

-Know Your Risk Appetite: As you get closer to retirement, keep your "living expense" assets in cash, US government inflation linked bonds, or German bund linkers (basically a mix of "risk-free" assets). Take risks only with assets you plan to donate or give away. Consider this thought-experiment: if you lost *all* your risky assets tomorrow, would your risk-free assets get you by for the rest of your life?

-Be Paranoid with Redundancy/Backups:
Keep retirement cash in multiple banks in multiple "safe" countries, and consider keeping a safe store nearby in a safe house or as precious items (gold coins, silverware, portable antiquities, etc.).

Investment Advice from the Talmud - Alpha

Some ancient wisdom on asset allocation:

SOURCE: Gibson, Asset Allocation, 4th Ed. (2008)

Rab, who lived in the third century, noticed the ears of corn being fanned by the breeze, and declared "However much you may fan, it is better to devote oneself to commerce" (ibid.). On the other hand, it is also said, "A man who does not possess a piece of land is not fit to be called a man" (ibid.); and another Rabbi adopts a middle course by advising "Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep by him in reserve" (B. M. 42a).
SOURCE: Ancient Jewish Proverbs, by Abraham Cohen, [1911]

Compare this with the 2008 Yale Endowment Fund's reported targets (Yale is the undisputed intellectual leader of institutional investing in the US, if not the world):



Translating Yale into the Talmud buckets, it has 67% in stocks, 4% in bonds, and 29% in real estate. This looks unbalanced, and 2008 showed it was. But I doubt that Yale's Swenson or other lemmings in the institutional investing world learned that lesson.

NOTE: Sorry for the three posts on the same day - I have been writing these over the last month but only had the time to post today.

The US's Relative Economic Position and Manufacturing - An Argument Without Numbers - Alpha

Big Picture US Outlook: For the macro situation, I expect the US's situation over the next 20 years to be similar to the UK from 1950-1970, or Japan from 1990-2010 (very bad times for both countries). Both remained rich countries, per capita, leading the world, but their relative wealth came down (as it should if poorer countries grow faster). Britain's debates about the importance of manufacturing and concern about its decline started in the early 1900s with PM Asquith on, and its overall share of world manufacturing output declined. See: British Decline

Basics on Growth: Stepping back to the big picture, a country can only get richer in real terms if it produces more with the same resources (productivity), or finds/makes a new natural resource that is very valuable (oil in the desert, silicon in computers, etc.). Countries then trade what they can produce most efficiently in relation to others, and everyone is richer. If one country consistently imports more than it exports, in the long run, woe to it! Also, it's common sense that the best productivity gains and increases in material wealth come from manufacturing, whether physical like cheerios or intellectual like software, because producers get economies of scale and scope. Now the question is whether the US will be more like the UK or Japan.

Analogy to the UK: If the US loses manufacturing and keeps high current account and fiscal deficits, then the UK is the better analogy: the currency depreciates, manufacturing gets liquidated and the country's economic base degrades to services, many of which are low-value add. High value add services, like law, medicine, and finance, still stay because they are the result of technology, the rule of law, and better transparency/governance (these are supported by Anglo-American institutions, like universities, republican democracies, more minority rights, and common law courts, which span the globe through the US, Canada, UK, and Australia).

Analogy to Japan: If the US manages to create/upgrade manufacturing and and reduce current account deficits (fiscal deficits sadly are here to stay until taxes are raised again), then Japan is the better analogy: currency stays weak, and if the US can, it pursues a mercantilist export-led strategy and slowly improves its NIIP. This doesn't seem too likely. Beyond banking/deleveraging, Japan isn't the right analogy (the demographics of their cultural habits and population are too different - Americans are much more like spendthrift Brits). One of the best macro books on Japan is Koo's "Balance Sheet Recession", with a review here.

Promising Macro Themes: I am most positive about mid to large corporations in the Anglo-American countries (UK-US-Canada-Australia, or GBP-USD-CAN-AUS, or GUCA countries), which do heavy business in the BICA countries (Brazil, India, China, and Greater Asia which includes Malaysia, Indonesia, Vietnam, etc.). But even multinationals can get screwed in BICA countries, and the Danone/Wahaha example is only one of many. Sorry to throw around the acronyms, but I will start referring to GUCA and BICA, and throw out the silly BRIC acronym (because Russia is worthless, a dead end). I trust GUCA corporations/jurisdictions more than the BICA, but BICA is where the growth is. Also, high-tech in GUCA will always do well, as there will always be more Googles, Apples, RIMMs, etc. every decade to keep the engines going.

Bottom Line: In investing, you have to follow the social and economic demographics about where wealth is created. Today, that means tech in the west and goods in the east. Buy GUCA companies that focus on BICA countries, or GUCA companies that innovate through tech.

Perfect Market Timing: A Thought Experiment - Alpha

Question: What would your returns be if you could perfectly time the market?

Set up: Buy t-bills (USGG3M) or the market (SPX), whichever will have a higher return (assuming perfect knowledge/foresight), at the beginning of the month and sell at the end of the month.

Time Period and Initial Condition
: From January 1954 through May 2009 (~55 years), $1000 pool of capital. The experiment's control is to buy and hold the SPX, with no annual tax consequences and no transaction costs.

Results (CAGR):
No taxes and transactions costs: $1.22 billion (28.8%)

35% annual tax rate but no transactions costs: $22.97 million (19.9%)

Buy-and-hold SPX (control): $35,243 (6.6%)

But as Charlie Munger said, "Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things."
Perfect market timing is impossible.

Friday, July 3, 2009

The Mean Reversion Fallacy - Ari Paul

Just about every analysis of the economy and stock market looks to the last 90 years to predict the future. We look at the US markets from 1920 mostly because we just don’t have good data from earlier times. Benjamin Graham, the father of value investing, based much of his analysis on the observation that the US market since 1920 had meandered from highs to lows with a general upward trend. Warren Buffett employed the same kind of empirical mean reversion strategy, famously saying, “It’s never paid to bet against America.” The same observations and predictions could have been successfully employed in the Netherlands, France, England, and even the Holy Roman Empire at different times. Mean reversion works until it doesn’t. Will the next 90 years of US stock returns look the same as the previous 90?

The assumption that equities will moderately outpace inflation over time is primarily empirical but also contains direct logical inferences that I'll confront. We assume that the continuous investment in capital and new technological discoveries will lead to growth in productivity. At least some of this productivity growth is likely to be captured by publicly traded companies, and thus equities should do well. As general statements these are quite reasonable, but history is littered with counterexamples. One such example is the financial industry of the US over the last 40 years. It's difficult to come up with exact numbers, but it's likely that despite tremendous earnings growth, investors have actually lost after inflation by investing in financial equities. The reason is that corporate earnings were spent on inflated salaries, diluted by new issuance to insiders, and lost to fraud, rather than enriching shareholders.

Another issue is that while the history of mankind over 3000 years has been of rising productivity, it has been neither continuous nor evenly dispersed. Empires have risen and fallen. The causes of an empire's decline are outside the scope of this post, but like a highflying growth stock, deterioration is a safer bet than that dominance will continue indefinitely. Under severe inflation, a currency collapse, an overthrow of the government, a devastating war, or simply a slow deterioration, equities may produce indefinite negative real returns.