| Arete Insights Q412 |
Welcome
One of the great things about living in the times we do is that it is so cheap and easy to get information. For an admitted “lover of wisdom” and data geek like me, these conditions could hardly be more favorable; it’s like a playground. For more “normal” people, however, the flurry of information can seem like a blizzard that often obscures important issues.
Realizing this, I have begun testing a new tool to help people navigate a clearer path through the investment landscape. I mentioned this in the last Arete Quarterly when I mentioned “a knowledge database constructed out of the pieces of information I gather on a regular basis.” I am happy to report that I am making significant progress on this initiative and look forward to getting comments and feedback to make it as useful as possible for investors. If all goes well, I will plan on offering it as a subscription service.
The database takes the form of a wiki and is designed to be an amalgamation of information, insights, and knowledge. It is also designed to help investors gain perspective and to better address a wide variety of common investment issues. It is easiest to think of it as a digital extension of the files and information I already manage on a regular basis.
The wiki project originated out of a desire to be able to serve investors who are facing a number of challenges but have limited resources with which to meet them. Since so many investment services are “sold”, investors often only hear one side of a story, and generally a very biased one at that. This situation further exacerbates the challenges wrought by a difficult investment environment that demands more attention. A common theme I hear is that people would like to be better able to get their arms around things so they can get more confident in their investing.
This project is also an attempt to address what I perceive are some important bottlenecks in the investment services industry. Given the vast number of financial services employees and offerings there is a lot of noise and it can be hard to tell the bad stuff from the good. Even among the higher quality organizations and advisors, investors are often disappointed with how little of the expertise trickles down to them in the form of material benefit.
In other words, there seems to be a problem with either the delivery of investment expertise, or with the conversion of expertise into realized benefits. For a number of reasons, I sense there is an opportunity to more effectively provide useful and objective insights and I hope the AreteResearch wiki can address some of the challenges investors face.
There is no doubt that I have fun doing investment research and that I truly enjoy sharing insights, both of which make a project like this easier. If you have an interest in taking a look, please let me know; I’d love to hear your feedback. If there are simple things I can do to make it more useful, it will help everybody. Hopefully, together, we can keep making this challenge called investing better!
Best regards,
David Robertson, CFA
CEO, Portfolio Manager
One of the great things about living in the times we do is that it is so cheap and easy to get information. For an admitted “lover of wisdom” and data geek like me, these conditions could hardly be more favorable; it’s like a playground. For more “normal” people, however, the flurry of information can seem like a blizzard that often obscures important issues.
Realizing this, I have begun testing a new tool to help people navigate a clearer path through the investment landscape. I mentioned this in the last Arete Quarterly when I mentioned “a knowledge database constructed out of the pieces of information I gather on a regular basis.” I am happy to report that I am making significant progress on this initiative and look forward to getting comments and feedback to make it as useful as possible for investors. If all goes well, I will plan on offering it as a subscription service.
The database takes the form of a wiki and is designed to be an amalgamation of information, insights, and knowledge. It is also designed to help investors gain perspective and to better address a wide variety of common investment issues. It is easiest to think of it as a digital extension of the files and information I already manage on a regular basis.
The wiki project originated out of a desire to be able to serve investors who are facing a number of challenges but have limited resources with which to meet them. Since so many investment services are “sold”, investors often only hear one side of a story, and generally a very biased one at that. This situation further exacerbates the challenges wrought by a difficult investment environment that demands more attention. A common theme I hear is that people would like to be better able to get their arms around things so they can get more confident in their investing.
This project is also an attempt to address what I perceive are some important bottlenecks in the investment services industry. Given the vast number of financial services employees and offerings there is a lot of noise and it can be hard to tell the bad stuff from the good. Even among the higher quality organizations and advisors, investors are often disappointed with how little of the expertise trickles down to them in the form of material benefit.
In other words, there seems to be a problem with either the delivery of investment expertise, or with the conversion of expertise into realized benefits. For a number of reasons, I sense there is an opportunity to more effectively provide useful and objective insights and I hope the AreteResearch wiki can address some of the challenges investors face.
There is no doubt that I have fun doing investment research and that I truly enjoy sharing insights, both of which make a project like this easier. If you have an interest in taking a look, please let me know; I’d love to hear your feedback. If there are simple things I can do to make it more useful, it will help everybody. Hopefully, together, we can keep making this challenge called investing better!
Best regards,
David Robertson, CFA
CEO, Portfolio Manager
Insights
Turn on the TV and you’re likely to hear “Stocks are cheap!” mainly from equity managers and “Beware deflation!” mainly from bond managers. How can you tell who’s telling the truth? Importantly, what does it suggest as to what you should do?
Our qualified assessment is that stocks are decent long-term investments, but a great deal of selectivity should be exercised. This assessment belies a great deal of nuance which can provide useful context for investors, however.
One part of the analysis is clear: At current yields, bonds are terrible long-term investments. Jim Grant, the thoughtful and widely respected editor of Grant’s Interest Rate Observer dubbed Treasurys as “return free risk.” While there may be some opportunities outside of the US, by and large, we do believe that stocks are far more attractive than bonds.
That makes stocks relatively attractive, but it does not necessarily make them attractive on an absolute basis. This is an important distinction too often glossed over in television soundbites. More specifically, just because stocks are better long-term investment propositions than bonds right now doesn’t mean one should back up the truck either.
The real question, and the crux of fiduciary duty, is to determine which assets have favorable risk/return tradeoffs and therefore make attractive investments. The unfortunate truth, which we have mentioned several times over the past couple of years, is that there are significant risks to owning stocks and some of these risks are rising. These risks serve to mitigate the attractiveness of stocks on an absolute basis.
One risk is that a set of long-term valuation measures that have proven very effective in the past point to stocks being very expensive right now. While many pundits and practitioners bandy about metrics that corroborate their views, far too often these metrics fail to withstand the test of efficacy (i.e. they don’t work; they are not useful in framing future performance).
Another risk is that corporate profitability is exceptionally high now which flatters already expensive valuations. Since a stock is a long lived asset, an appropriate valuation should normalize profitability over the life of the asset. The current market, to the contrary, appears to be discounting the indefinite continuation of record profitability. Receding profitability levels and valuations are both likely to likely to impede future stock performance.
Finally, one of the most important lessons to emerge from the financial crisis of 2008-09 is that credit affects valuation. The more money that is available to buy assets, the higher prices go. Between 1964 and 2007, total credit in the US expanded at a rate of 9.5% per year, far greater than nominal economic growth of 7.35%. The excess went to inflating assets like stocks in 2000 and house prices in the mid 2000s. Now that deleveraging is underway, the process will reverse and less credit will put downward pressure on asset prices.
There are a couple of key lessons from this analysis. One is that favoring stocks over bonds may lead to a better investment, but not necessarily to a good investment. This doesn’t mean things are hopeless, only that one needs to be patient until better opportunities arise. Second, the major stock indexes are not cheap which means there is a high probability that future returns will fail to compensate adequately for bearing the risk. Finally, despite these caveats, there are interesting stock ideas out there. The opportunities to generate distinctive performance through opportunistic stock selection are becoming quite significant.
Turn on the TV and you’re likely to hear “Stocks are cheap!” mainly from equity managers and “Beware deflation!” mainly from bond managers. How can you tell who’s telling the truth? Importantly, what does it suggest as to what you should do?
Our qualified assessment is that stocks are decent long-term investments, but a great deal of selectivity should be exercised. This assessment belies a great deal of nuance which can provide useful context for investors, however.
One part of the analysis is clear: At current yields, bonds are terrible long-term investments. Jim Grant, the thoughtful and widely respected editor of Grant’s Interest Rate Observer dubbed Treasurys as “return free risk.” While there may be some opportunities outside of the US, by and large, we do believe that stocks are far more attractive than bonds.
That makes stocks relatively attractive, but it does not necessarily make them attractive on an absolute basis. This is an important distinction too often glossed over in television soundbites. More specifically, just because stocks are better long-term investment propositions than bonds right now doesn’t mean one should back up the truck either.
The real question, and the crux of fiduciary duty, is to determine which assets have favorable risk/return tradeoffs and therefore make attractive investments. The unfortunate truth, which we have mentioned several times over the past couple of years, is that there are significant risks to owning stocks and some of these risks are rising. These risks serve to mitigate the attractiveness of stocks on an absolute basis.
One risk is that a set of long-term valuation measures that have proven very effective in the past point to stocks being very expensive right now. While many pundits and practitioners bandy about metrics that corroborate their views, far too often these metrics fail to withstand the test of efficacy (i.e. they don’t work; they are not useful in framing future performance).
Another risk is that corporate profitability is exceptionally high now which flatters already expensive valuations. Since a stock is a long lived asset, an appropriate valuation should normalize profitability over the life of the asset. The current market, to the contrary, appears to be discounting the indefinite continuation of record profitability. Receding profitability levels and valuations are both likely to likely to impede future stock performance.
Finally, one of the most important lessons to emerge from the financial crisis of 2008-09 is that credit affects valuation. The more money that is available to buy assets, the higher prices go. Between 1964 and 2007, total credit in the US expanded at a rate of 9.5% per year, far greater than nominal economic growth of 7.35%. The excess went to inflating assets like stocks in 2000 and house prices in the mid 2000s. Now that deleveraging is underway, the process will reverse and less credit will put downward pressure on asset prices.
There are a couple of key lessons from this analysis. One is that favoring stocks over bonds may lead to a better investment, but not necessarily to a good investment. This doesn’t mean things are hopeless, only that one needs to be patient until better opportunities arise. Second, the major stock indexes are not cheap which means there is a high probability that future returns will fail to compensate adequately for bearing the risk. Finally, despite these caveats, there are interesting stock ideas out there. The opportunities to generate distinctive performance through opportunistic stock selection are becoming quite significant.
Lessons from the Trenches
One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works. “Lessons from the Trenches” highlights our approach to stock research. Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.
In the last edition of Arete Insights, we discussed the usefulness of having valuation landmarks in order to navigate a landscape of uncertainty successfully. Another useful skill set for navigating an uncertain environment is a better understanding of oneself. Behavioral economics has gone a long way in explaining why we do a lot of the (sometimes unhelpful) things we do. More recently, research in neuroscience reveals how our physiological reactions to the environment affect both our perception and interpretation of information around us.
The recent book, The Hour Between Dog and Wolf: Risk Taking, Gut Feelings, and the Biology of Boom and Bust, by John Coates, provides wonderful insights from neuroscience and Wall Street trading to show how our bodily responses to stress (and success) affect both what we see and how we think.
Coates describes, “As cortisol levels rise, and our exposure to the hormone becomes chronic, we increasingly recall the events that were stored under its influence. Scott [fictional trader] now finds he recollects mostly disturbing memories. He tends to dwell on nasty events— failing high-school calculus, a locker-room fight, losses during the dot-com crash— rather than pleasant ones, like meeting his girlfriend, vacations in Verbier or trades he got right. Importantly, when assessing a trade, Scott now increasingly draws on negative precedents in determining the risks, and such a selective recall of things going wrong may promote an irrational risk aversion.”
Unfortunately this largely automatic response leaves us ill-equipped to deal with the stress of uncertainty. Coates continues, “Scott needs to think clearly about his position and the market, but oddly, inappropriately, his body has atavistically prepared him to fight with or run away from a bear. The stress response is prehistorically hamfisted in this regard. It does not distinguish very clearly between physical, psychological and social threats, and it triggers much the same bodily response to each one. In this way the stress response, so valuable in the woods, can prove archaic and dysfunctional when displaced onto the trading floor, or for that matter any workplace. We need to think, not run.”
As the body’s stress response inhibits our cognitive activity, the thinking we can conjure is often misdirected. “One of the main jobs of consciousness is to keep our life tied together into a coherent story, a self-concept. In other words, we make things up.” As a result, when we are pressed and scrambling to make sense of things, we tend to focus more on contriving a positive spin on the situation rather than resolving a challenge.
If these challenges are not enough, we also seem virtually incapable of even knowing whether we are in a state of stress or not. “What I [Coates] found was that their [traders’] opinions on how stressed they were had little if anything to do with reality, nothing to do with the fact that they might be losing money, or that their trading results seemed more than usually uncontrollable, or with market uncertainty as measured by its volatility. In fact, their opinions had little to do with anything I could discern.”
While the insights from Coates’ work may seem daunting, they provide a very useful lesson to investors. Namely, when people think of factors that generate lasting benefits to investment performance, they often think of things like access to information and analytical skills. Coates’ work suggests that we also need to add our physiological responses to the top of the list of factors that can affect investment performance.
It is normal for any of us to experience some degree of stress when confronted with novelty and uncertainty. This isn’t necessarily bad when the level of stress is manageable. However, when the risks rise and more is at stake (like our ability to retire or to maintain a standard of living, for example), stress can rise to unhealthy levels. When it does, our physiological responses cloud our vision of any landmarks we may have established.
As can be imagined from the discussion, there are no easy answers. It is possible, however, to increase one’s resilience to challenges through training, and this should be considered by anyone who is regularly tasked with making important decisions. That said, it is also important to be aware that extended exposure to stress (or success) can affect our perception of things. This should be considered a risk and a limit to what we can “know”.
One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works. “Lessons from the Trenches” highlights our approach to stock research. Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.
In the last edition of Arete Insights, we discussed the usefulness of having valuation landmarks in order to navigate a landscape of uncertainty successfully. Another useful skill set for navigating an uncertain environment is a better understanding of oneself. Behavioral economics has gone a long way in explaining why we do a lot of the (sometimes unhelpful) things we do. More recently, research in neuroscience reveals how our physiological reactions to the environment affect both our perception and interpretation of information around us.
The recent book, The Hour Between Dog and Wolf: Risk Taking, Gut Feelings, and the Biology of Boom and Bust, by John Coates, provides wonderful insights from neuroscience and Wall Street trading to show how our bodily responses to stress (and success) affect both what we see and how we think.
Coates describes, “As cortisol levels rise, and our exposure to the hormone becomes chronic, we increasingly recall the events that were stored under its influence. Scott [fictional trader] now finds he recollects mostly disturbing memories. He tends to dwell on nasty events— failing high-school calculus, a locker-room fight, losses during the dot-com crash— rather than pleasant ones, like meeting his girlfriend, vacations in Verbier or trades he got right. Importantly, when assessing a trade, Scott now increasingly draws on negative precedents in determining the risks, and such a selective recall of things going wrong may promote an irrational risk aversion.”
Unfortunately this largely automatic response leaves us ill-equipped to deal with the stress of uncertainty. Coates continues, “Scott needs to think clearly about his position and the market, but oddly, inappropriately, his body has atavistically prepared him to fight with or run away from a bear. The stress response is prehistorically hamfisted in this regard. It does not distinguish very clearly between physical, psychological and social threats, and it triggers much the same bodily response to each one. In this way the stress response, so valuable in the woods, can prove archaic and dysfunctional when displaced onto the trading floor, or for that matter any workplace. We need to think, not run.”
As the body’s stress response inhibits our cognitive activity, the thinking we can conjure is often misdirected. “One of the main jobs of consciousness is to keep our life tied together into a coherent story, a self-concept. In other words, we make things up.” As a result, when we are pressed and scrambling to make sense of things, we tend to focus more on contriving a positive spin on the situation rather than resolving a challenge.
If these challenges are not enough, we also seem virtually incapable of even knowing whether we are in a state of stress or not. “What I [Coates] found was that their [traders’] opinions on how stressed they were had little if anything to do with reality, nothing to do with the fact that they might be losing money, or that their trading results seemed more than usually uncontrollable, or with market uncertainty as measured by its volatility. In fact, their opinions had little to do with anything I could discern.”
While the insights from Coates’ work may seem daunting, they provide a very useful lesson to investors. Namely, when people think of factors that generate lasting benefits to investment performance, they often think of things like access to information and analytical skills. Coates’ work suggests that we also need to add our physiological responses to the top of the list of factors that can affect investment performance.
It is normal for any of us to experience some degree of stress when confronted with novelty and uncertainty. This isn’t necessarily bad when the level of stress is manageable. However, when the risks rise and more is at stake (like our ability to retire or to maintain a standard of living, for example), stress can rise to unhealthy levels. When it does, our physiological responses cloud our vision of any landmarks we may have established.
As can be imagined from the discussion, there are no easy answers. It is possible, however, to increase one’s resilience to challenges through training, and this should be considered by anyone who is regularly tasked with making important decisions. That said, it is also important to be aware that extended exposure to stress (or success) can affect our perception of things. This should be considered a risk and a limit to what we can “know”.
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