Thoughts

Don’t want to be vulnerable to this – and I believe a big part of risk on in this environment is tied to that dynamic as opposed to outright fundamental bullishness on a cycle or pro-growth backdrop… Very hard to construct a fundamentally sound bullish argument that doesn’t require a lot of things to move in the right direction to justify a credible and attractive risk/reward environment.

Interview with Ken Fisher writing Templeton on bull markets – born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.

Seems obvious that we’re not in those latter states. So if the past is prelude then the trajectory of the market would remain up.

Kind of a depressing prospect given current fundamentals and earnings multiples.

Fed signal or just more noise?

Scraping rates off of zero after nearly a full decade of super-accommodation.  Seems like it should be momentous.

After reading this long, but excellent interview with the Chief Economist at Hoisington Asset Management, I’m left rethinking my previously reluctantly bullish view on risk assets broadly and equities in particular. I had been thinking that global political and monetary forces would be effective in their reflationary efforts if for no other reason than persistence or bullheadedness and lack of viable attractive alternatives. If they want inflation and keep running the printing presses in a global race to debasement, eventually you’ll get what you wished for – and in that environment you had better own something that can keep up.

After reading this this, I’m not so sure. Because of the amount of indebtedness globally and the level of delevering required to get to sustainable levels – pumping more money into the system may never result in the reinvigorated economic growth it is attempting to achieve. and the bigger danger is that it will lull us back into complacency allowing us to keep forestalling dealing with unpleasant reality that the structure of the current global economy is far from stable or sustainable.

He goes into some detail on the current global debt mess, the implications this is likely to have on the US and global economies, and a good amount of historical context for thinking about the current environment.

My main takeaways are: 1)The US is the prettiest ugly girl in the room, 2) Exports are likely to be under pressure by sustained relative strength of the dollar, 3) Real growth is going to be scarce for a really long time, 4) Longer term, austerity measures are the only answer – we’re not going to grow out of this problem or solve it with debt stimulus.

Beyond just saying – ‘ I want stocks that go up’, here’s an attempt at a succinct summary of what I’m trying to focus on investing in:

– Multi-year Secular Growth:  Growth investing means putting capital to work in businesses where end-market demand, market forces, or competitive opportunities signal that a small company is on a path to become much bigger.  Obvious certainly, but sometimes lost in a world of  ‘short term-ism’ and fixation on EPS growth.  (Share buybacks, while nice, are not growth.)
– Modest or Moderated Expectations: The best risk/reward opportunities are usually undervalued quality companies.  No matter how great the business, if that greatness is already recognized or reflected in forward operating projections, the risk/reward is necessarily compromised to some degree.
– Under-followed or Neglected by the Street: Taking a step back from investment theory – in the end stock price fluctuations are driven by supply and demand for a particular security.  By focusing more time on looking at under-followed companies, you skew the balance of probabilities towards lower-demand securities.  If those companies subsequently execute on a growth opportunity, they’ll no longer be neglected by the Street – allowing a repricing of the security as a result of rising demand.  This is a way of getting at being contrarian without accepting as much volatility or headline risk.
– Unique Business: More difficult to spell out precisely, but unique businesses often benefit from more relaxed competitive pressures, often have longer growth trajectories (if perhaps less steep), and benefit from a compelling investment narrative – as a result of standing out from the crowd.  If nobody else is doing what you do, and you happen to do it well – all the investor attention comes to you (clearly this can be a double-edged sword).  This also ties into Blue Ocean strategy – go where others aren’t.  Unique businesses are often those that are forging new industries and new end-market demand and, because fewer competitors are there, they are often more innovative and focused on the creative process – than just trying to make the quarter.  (Unique alone won’t cut it though – must maintain quality and valuation discipline to preserver risk/reward.)

Elegant framework for gauging and monitoring investments.  By focusing on stock ideas that have a clearly identifiable ‘narrative’ – you provide yourself a convenient due diligence tool.  The narrative becomes the straight and narrow that the stock must proceed along.  As long as the current situation is consistent with your narrative the stock is appropriate – if it diverges – the narrative needs to be updated or the stock needs to be sold.  The Narrative becomes the qualitative manifestation of your ‘path of future intrinsic fair value’.

Simplifies not only the ongoing due diligence, but also client communication.  Makes the investment process more scale-able and keeps the analyst from getting bogged down in the necessary weeds of minor details.

A good narrative should be succinct enough to get through in less than a minute.  It should capture answers to 1)Key Drivers, 2)Why Now?, and 3)A Kicker or Sweetener.  And ideally, it should help the analyst gain comfort in the thesis’ potential appeal – if there is a compelling narrative for the stocks future, it is far more likely to become more broadly understood and be rewarded with a premium valuation.

An investment portfolio that incorporates bets that stocks will fall in value inherently involves speculation.  Whether that speculation hinges on mis-valuation or deteriorating fundamentals, it is still not a pure ‘investment’ in the ‘Graham & Dodd’ sense of the term – an allocation of capital with an expectation of an economic return.

Given this constraint, how can you work to incorporate this type of speculation into an investment portfolio, consistent with a disciplined long-term approach, in a way that enhances the investor’s ability to add alpha to the portfolio, mute volatility, and improve the portfolio’s risk controls rather than deteriorate them?

My intuition suggests that a portfolio structure that oscillates between 80% and 150% net long exposure (depending on market conditions and risk/rewards trade offs available) – offers the most dependable framework for long-term superior performance.  Going beyond that band risks allowing the speculation to outweigh the investment.

Except in extremely rare circumstances, I think arbitrage speculations (M&A, Converts, Paired trades) require too much risk capital for too little potential gains (accepting Black Swan risk in often crowded trades).  In my mind, short positions should be limited to securities where there are clear flaws in business model.  Either through obsolescence that the market recognizes, deteriorating fundatmentasl that will result in cash flow draining from the company, or near-term catalysts that will cause momentum investors to capitulate.

For the same reasons that buying a long position without growth drivers or catalysts just because it’s cheap (it can always get cheaper) is dangerous, the reverse is even more dangerous – particularly because the risk exposure and position grows as you get more wrong.

In the context of risk management, big positions on the short size are very dangerous from a behavioral perspective (easy place for investors to get themselves in trouble).  Also, it’s critical to recognize that technicals matter more here, and ‘crowded shorts’ pose just as much (if not more) risk than popular momentum trades on the long side – capitulations can be even more devastating.

In sumary – I believe a long-short approach is consistent with my investing ‘world-view’ albeit it with a constrained and limited application.  In my opinion, mixing “Market-neutral’ and bottom-up stock-picking is a difficult proposition – not only to achieve, but also to convince investors that they should participate.

Two really excellent interviews.

Consuela Mack interviews Mark Holowesko, who I’d never heard of but who became Templeton’s director of Research/PM at 27, and runs a Global Value product as Holowesko Partners today.  He’s an avid cyclist and his firm sponsor the Garmin Cervelo team.  On a multitude of angles, his investment views line up with my less-developed investing “world-view” and is good framework for fleshing out a more articulated view.

Charlie Rose’s extended interview of Seth Klarman is a special gem – Klarman has remarkebly few public appearances.  He touches on philanthropy, importance of Ben Graham’s legacy, and the staying power of his book.  Also a lot of valuable perspective from a really smart guy on the current economic mess – role of government, moral hazard, leverage, and being contrarian. (Look at minute 34 in the Klarman interview – comments on the bias of institutional influence – erosion in value proposition of investment stewardship.)

I’m late to the game on this subject and article in the NYT.  Fascinating material and really puts in perspective the potential for disruption and change available from the building blocks in place today.  It’s easy to forget the power of innovation and driving change against a backdrop of economic turmoil and deflationary pressures, but this perspective really drives home the importance of being involved in and exposed to technology from an investing perspective as well as just general base of knowledge and familiarity.

More handwringing observations on the power of the 1%, but still I see little out there offering pragmatic solutions.  Stiglitz piece from Vanity Fair talks about the distortions and economic costs of an uneven playing field.  Lucid framework for observing the structural problems – I guess understanding the dynamics of the dangerously flawed status quo is a good starting point to understanding what mechanisms got us to this place and how to begin to reverse or dismantle that system in the least painful way.