Written by Lance
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25 February 2010
Occasionally you read something that makes you go "WOW!" Jeremy Grantham in at least half of his Quarterly Letters comes close. The other half of the time he definitely scores.
Another person who generally has the same effect, and like Jeremy was a true hero to clients who really listened over the last decade, is James Montier. First at Dresdner Kleinwort, and then Société Générale (with another gem, his colleague Albert Edwards) James expounded on value investing, behavioral finance and the perils of modern finance. Not that the bankers of Société Générale listened.
In a career move that makes perfect sense James has now joined Jeremy at GMO. With James and Ben Inker the GMO team will deserve respect long after Jeremy is gone.
Which gets me back to WoW!
James has produced an analysis of the crisis and its aftermath that is close to perfect. Not only are the ten points and his discussion enlightening in and of themselves, but the wisdom of other great investors is liberally sprinkled throughout. This is one of those pieces that says exactly what I think about a host of issues, but better. Here are a few highlights:
Lesson 1: Markets aren’t efficient.
One would think this would be obvious by now, but no, it isn't to many.
Lesson 2: Relative performance is a dangerous game.
Personally I believe that it is to the benefit of those of us who refuse to play the relative performance game, but managers, consultants and the industry in general conspire against looking at things differently. On the subject of the industries obsession with deciding how to categorize returns as alpha or beta or any number of ever finer benchmarks:
Sadly, these concepts are nothing more than a distraction from the true aim of investment, which as the late, great Sir John Templeton observed is, “Maximum total real returns after tax.”
Such a simplistic mind you have James worrying about what ends up in the bank account rather than beating a benchmark or proving your results are "alpha" rather than beta. It is also nice to see James noticing studies which show managers can beat an index, they bizarrely choose not to. Go figure.
Lesson 3: The time is never different.
We better hope it is this time, because the history of collapsing credit bubbles certainly argues for several years of economic distress.
Lesson 4: Valuation matters.
Ultimately nothing has a greater impact on returns in the stock market than the price you pay. This is consistently denigrated but consistently proves true over time:
Oh, and in case you were wondering, we presently reside on the expensive end of that chart.
Lesson 5: Wait for the fat pitch.
The problem with this is that investors are impatient:
As tempting as it may be to be a “man of action,” it often makes more sense to act only at extremes. But the discipline required to “do nothing” for long periods of time is not often seen. As noted above, overt myopia also contributes to our inability to sit back, trying to understand the overall investment backdrop.
Waiting for the "fat pitch" as Warren Buffett calls it requires one to realize:
- cash is a position
- that it is okay not to do as well as everyone else while waiting for the right opportunity
- the necessity of investing in opportunities not dependent on the stock markets direction
- that you should respect dividends
- you need to act when everyone else is in a state of panic
- that it is only useful to panic if you do so before everyone else!
Warren Buffett often speaks of the importance of waiting for the fat pitch – that perfect moment when patience is rewarded as the ball meets the sweet spot. However, most investors seem unable to wait, forcing themselves into action at every available opportunity, swinging at every pitch, as it were.
Lesson 6: Sentiment matters.
The more enthusiastic investors are, the more cautious you should be, and vice versa.
Lesson 7: Leverage can’t make a bad investment good, but it can make a good investment bad!
In and of itself modest leverage can help a good investment, but only if you can live with the volatility long enough for the good investment to pay off. Excessive leverage destroys the ability to hold.
Lesson 8: Over-quantification hides real risk.
James quotes the great Ben Graham:
Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw there from ... Whenever calculus is brought in, or higher algebra, you could take it as a warning that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.
This lesson especially appeals to me. As a long time fan of the "Its Bigger Than a Bread Box" school of investing I cannot agree more with the false sense of certainty and its dangers in applied investing. What I mean by "bigger than a bread box" goes back to lesson 6 and it paying most to act at extremes. Precision is not only unattainable then, but irrelevant. Look for something so important that getting it exactly right isn't important. Everything else will likely amount to no more than short term noise. I remember an investment committee meeting in early 2008 as the downturn we had been preparing for was in its early innings. The debate was going back and forth over how bad things might get. I decide it was time to cut to the chase:
Debating how bad things might get is like arguing after you have fallen off a building whether it is a 30 or 60 story fall. Either way you are dead. The real solution is the same either way, don't fall off the damn building!
We moved on to how we should protect our capital and hopefully even profit from the coming collapse. Here is another gem from James on how trying to mathematically calculate risk distracts us from what really matters:
In a depressing parody of the “build it and they will come” mentality, the risk management industry seems to believe “measure it, and it must be useful.” In investing, all too often risk is equated with volatility. This is nonsense. Risk isn’t volatility, it is the permanent loss of capital. Volatility creates opportunity. As Keynes noted, “It is largely fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”
We would be far better off if we abandoned our obsession with measurement in favor of understanding a trinity of risks. From an investment point of view, there are three main paths to the permanent loss of capital: valuation risk (buying an overvalued asset), business risk (fundamental problems), and financing risk (leverage). By understanding these three elements, we should get a much better understanding of the true nature of risk.
Interestingly, it is valuation risk which has proved hardest to avoid, and causes the most lasting damage to investors portfolios.
Lesson 9: Macro matters.
Big macro economic events can destroy what seems normal when it comes to valuation. The big risks need to be accounted for, even when they seem unlikely (bonus wisdom from the great Jean Marie Eveillard:
It often pays to remember the wise words of Jean-Marie Eveillard. “Sometimes, what matters is not so much how low the odds are that circumstances would turn quite negative, what matters more is what the consequences would be if that happens.” In terms of finance jargon, expected payoff has two components: expected return and probability. While the probability may be small, a truly appalling expected return can still result in a negative payoff.
[...]
Neither top-down nor bottom-up has a monopoly on insight. We should learn to integrate their dual perspectives.
Lesson 10: Look for sources of cheap insurance.
If low probability but disastrous events need to be accounted for, then finding ways to cheaply mitigate, or even profit from, them is important. Even if it is in the short term a drag on performance. Quality balance sheets in your stock holdings are cheap insurance right now, so are other strategies. We are closely looking at where cheap insurance can be found. Read Ten Lessons Not learnt
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