Learning by Doing

During a recent conversation on the purpose and benefits of blogging with my close friend, former classmate and multi-tasking Professor & serial entrepreneur Conor Neill, he made the following remark:

“Writing about what you know about would get boring fast, i.e. spewing out facts gathered during higher education…”

Ever since this talk I’ve been reflecting and have come to the conclusion that while obvious, it’s also absolutely true. From this, it follows that a blog is useful, potentially entertaining and enriching for both authors and readers insofar as it reflects a journey of discovery on a subject matter that is close the author’s heart. A mere mechanical regurgitation of a set of academic facts that is not accompanied by intellectual curiosity would simply not do the trick.

With this being my 17th blogpost, I can say that it would never have worked out had a genuine interest in the field and an almost insatiable thirst for learning not been there… Throughout this journey I started off with a heavy dose of deep-value philosophy; some would say a hardcore Ben Graham disciple. Whilst I am not about to perform a complete change of approach by any stretch of the imagination, adapting and evolving my firm beliefs is not out of the question.

Long-held hallmarks of “true” value investors include such sweeping mantras as, “the cycle doesn’t matter” and “a minute spent on macro issues, is a minute wasted”... Be that as it may, along this investing learning curve that I embarked upon some years ago (though publicly only since 0ct ’09), some valid challenges to the strict value approach have been raised. Among those, one of the more interesting exponents I’ve come across is a remarkable man by the name of Jeremy Grantham.

To listen to Mr. Grantham is in essence, akin to listening to pure wisdom. A born Yorkshireman, a place where by his own admission, “Scotsmen are considered spendthrifts”, Grantham could safely y be boxed in the value camp. However, as founder and Chief Strategist of GMO, he has built his business around the macro cycle and the principle of asset allocation, currently managing the princely sum of over 110 Billion, yes BILLION with a “B”, for institutional investors.

In his most recent Investor Letter, the GMO chief mocked the intellectual straightjacket” of Grahamites. Seeing their perception that investing without regard for asset bubbles is short on returns and most likely impossible to put in practice. In so doing, he cites the great JM Keynes:

“Investing based on genuine long-term expectation is so difficult today as to be scarcely practicable”

Though the statement dates to 1936, it certainly applies today. Having experienced more than out fair share of boom and doom in this first decade of the Millennium (think Dotcom crash ’00-’02 and Sub prime meltdown ’07-’09) few investors today would argue that ignoring the cycle is a wise approach. I, for one intend to at least incorporate core macro information into valuation assumptions.

So what does Mr Grantham or macroeconomics have to do with blogging and learning! Plenty. As this blog progresses I am relaxing my own “thought –corset” and broadening horizons by accepting new reference points without undermining the common sense that value investing is based upon.

I just hope that in so doing it makes “The Uncertain Future” a better read!

Process versus Results

For this instalment of my rambling thoughts on investing I’d like to start with an enlightening anecdote taken from Michael Lewis’ book “Moneyball”. In said title, one of the main characters relates the following story:

“I’m playing Blackjack in Las Vegas, a guy immediately to my right, sitting on a seventeen, asks for a hit. Everyone at the table stops, and even the dealer asks if he is sure. The player nods yes, and the dealer, of course, produces a four. What did the dealer say? “Nice hit.””

Nothing odd in that story you may be saying, after all, the player won big and the house lost, right? Outcome wise, there‘s nothing to contest as the results are evident enough. However, process wise, the approach of the blackjack player was unduly risky and fundamentally wrong.
This simple example of human nature at work draws attention to one of the most powerful concepts in investing: process versus outcome.

All too often, market participants (notice I choose my words carefully to avoid labelling all those that buy and sell securities as “investors”) dwell solely on outcomes without consideration of process. This behaviour is nonetheless quite understandable. Outcomes or results are for one self-evident and constitute simple references on which to evaluate performance. In western societies the relevance of results, be they in academic, professional or even sporting events can hardly be understated.

Well intentioned investors however, are remarkably prone to establish a causal and two-way relationship linking positive outcomes to good processes, as in the case of our daring blackjack player walking away from the table reminiscing of his excellent playing skills…. By the same token, bad outcomes are more likely than not to be interpreted as the result of a poor process. These long-held “truths” are in fact not so at all.

Investing is its most narrow definition is a probabilistic exercise and as such it shares a key trait with other such endeavours like competitive sports-team management and non-random games such as chess. All of these fields emphasize process over outcome. In simple terms a good outcome with a bad process can only de interpreted as “luck” while a good outcome following a good process should be correctly though of as statistically likely.

Investing greats concern themselves first and foremost with process. Any serious investor is quick to acknowledge that random walks are a key feature of short-term market performance. As such they plan for the long term where a sound process constitutes the cornerstone of investing policy. At times of (temporary) market dislocation, it is their well-honed and honest investing process that hey can take comfort in.

The old saying of “keeping your head when all around you are losing theirs” is tantamount to investing success. If not, just witness the 10% yield Mr Buffet is getting form GE and Goldman Sachs in exchanging for providing cash at just the right time in the not so distant depths of despair bear market of 2008. The question is, if you had Mr Buffet’s cash-hoard would you have put it to work with GE as its stock dropped precipitously and simultaneously lost its coveted AAA credit rating?

Whilst I can’t claim that I would have done the same as Mr Buffet and held a steady hand in the middle of the “perfect storm”, there’s something that I can do and that I am willing to share here right now. It is my own stock selection process for the UF Portfolio. It has two redeeming features: it is simple and yet painstaking.

Perhaps that’s the beauty.

Below is a schematic description of my process:

1. Source investing ideas: Screening for Low P/E, P/B EV/EBIT, Low debt, mature exchange
2. Read-10 years of 10K / 10Q : Identify normalised earnings, asset values
3. Read MD&A Section: Look for execution ability, consistency and foresight
4. Check for aligned interest: Insider ownership, other value investors, changes in ownership
5. Review competitive landscape: understand sector, key players, brand or scale advantages
6. Perform valuation: Set a range/target price based on Assets, Earnings power, market transactions

7. If the outcome of steps 1 to 6 is satisfactory AND current price is 35% below value then INVEST

Not everyone would be willing to go to into this much trouble just to select a stock.

After all, you can always just go on a message board , base your stock selection decisions on a perfect stranger's "gut feeling" and hope for the best.

However if you do strike it lucky (unlikely as that is), please don’t boast about your prowess and acknowledge the role of lady luck!

Broadening Horizons

Anyone bothering to take even a cursory glance at my bookshelves at home would be quick to point out the unusual concentration of value investing books. Whilst I profess to be an open-minded and inquisitive person, there is nothing in my book collection to suggest a digression from the theories I’ve been broadcasting in this blog.

Although it pains me to admit it, I have been suffering a severe bout of what psychologists label confirmation bias. Put another way, like most mortals I have been seeking information that merely conforms with and supports my pre-conceived opinions.

Apparently no amount of Daniel Kahneman’s, Michael Mauboussin’s or even James Montier’s books on investor psychology and behavioural finance will free me from falling into the very same traps that are so aptly described by these thought-provoking authors. Having spent several months extolling the virtues of the “value” approach to investing, the truth remains that very little time and effort has been assigned on my part to read-up on, let alone analyze, the virtues of rival investing schools and styles.

The last two weeks however, saw yours truly devoting valuable vacation time to perusing the less travelled path, or in my less-than-poetic case, the works of those advocating passive/index investing such as John Bogle, and growth investing, in this instance represented by Louis Navellier.

Truth be told, the theory behind passive / index investing is a sound one. After all, the asset management is by and large, a shameless return-reducing machine. All the same, in spite of the mounting evidence in favour of this rather placid, “sleep-easy” approach, I still find it hard to accept that it’s not even worth trying to “beat the market”.

Turning onto the other “rival” camp, the growth field is another story. Profitable growth is actually one of the three core components of any sound investing strategy. To borrow from the excellent writings of the respected Columbia University Professor Bruce Greenwald, the other two components (for the more curious readers out there) are:

1. Asset value
2. Earning Power

It’s plain to see that the precepts above are based, if not strictly on hard facts, then at least on readily ascertainable values. Profitable growth is, by its very nature, a tenuous variable that is notoriously difficult to forecast, let alone achieve. With the notable exception of heavily regulated sectors and monopolistic concerns, consistent growth is an unlikely feature at most companies.

Common sense notwithstanding, I’d go as far as to say that the growth “space” is populated by a combination of overly optimistic, often deluded, gambling types. These folk are masters in the greater fools game where price paid matters little and the supposed “investing” strategy is in fact a speculative pursuit that can be best labelled as “buy high, sell higher”.

Having gone full circle in my attempt to broaden investing horizons and rid myself of my self-fulfilling bias, I am happy to say that all investing in the literal sense of the word is by definition value investing.

Indeed, one would be right to question if there is any other type!