Sunday, January 20, 2013

The Art of Investing vs. The Discipline of Hard Science

Ruth and I spent Friday at “The Brain, a TEDx Caltech” event. From 10 am to 6 pm we were mesmerized by talks given by Caltech Professors, Post Docs, graduate  and undergraduate students plus a number of other professors and experts all focusing on the research that they are conducting on the brain. In a number of cases they described remarkable progress that they are making or expect to make on helping people with various maladies which were previously believed to be behavioral or muscular problems that when attacked through the brain will deliver thrilling results. As a carpenter who is only given a nail and a hammer and who thus thinks all problems can be attended to by driving a nail, my mind wandered through the presentations as to their applicability to the process and product of investing. (The Chief Investment Officer of Caltech and the incoming chair of the investment committee were also in the audience. I wonder what their takeaways from the day were? I hope to find out at our next meeting on Thursday.)

Brain Functions

Trial and Error is the way scientists and others learn. If you will, this is the application of the so-called scientific method to our observations.

When something does not work as expected (error) most scientists move on to do something different (trial). This is not the approach of a number of successful investors. They focus on why there was the failure and what could they learn from it; for example never again invest in technology or low price/earnings stocks. But why in this case, in this particular market, did the stock not perform as expected? This ties back to my belief that studying one’s losses is actually more beneficial than studying winners, which is another lesson I learned from handicapping thoroughbred horse races.

A good bit of the research on the brain examines the brain and behaviors of fruit flies and mice. At first there were thoughts that these small animals with simple understandable brains could easily depict how the human brain works. What the scientists discovered was while these animals were small they had complex brains. Though these small brains did not directly provide the medical solutions being sought, they did identify the complexities found within the brain. Whereas it would have been nice to find simple analyses to solve complex problems, that is rarely how things work-out in the real world. 

All too often a one page summary on the attractiveness of a security can be grossly misleading. Analytically, I grew up in a world where a thorough report would run upwards of a hundred pages and could take six-months to a year to produce. As the economics of both the buy-side and sell-side of Wall Street research has changed, the vast bulk of these types of reports are not being produced. Thus all too often an investment idea is not properly vetted. (Recently at both our fee-paying accounts as well as on the pro bono investment committees on which I serve, managers have been terminated not primarily due to performance, but because I believed their research was inadequate.)

In examining any universe for a particular trait or symptom, scientists divide the sample responses as “normal” and “novel.” If the universes are well chosen the normal represent about 95% of the participants and the novel represent 5%. What is significant is that in many characteristics, the 95% are relatively homogenous.  The novel components are often quite different from one another. From an analytical viewpoint the so-called novel components are the most interesting. In an attempt to estimate the loss potential of a collection of portfolios of loans, commodities, bonds, stocks, currencies, and derivatives, the auditors (at the urging of the regulators) have come up with a measure of variability, which is their attempt to quantify risks. From my standpoint, risk is the penalty paid by the beneficiaries of the account for a permanent reduction of meaningful capital, not variability of returns as measured by VAR. Thus you will see in the financial footnotes to various annual reports numbers that represent these calculations’ views as to the dollars that could be lost due to price variability 95% of the time. This is meant to be reassuring; however they are not to me. Ninety-five percent of a trading month is roughly 19 out of 20 trading days. Most of the time markets are reasonably well behaved and major declines do not happen often. I know of various single days that stock prices have declined more than the average down year. Further, just as the scientists are drawn to the novel components, I am concerned that portfolios analyzed in this manner have misunderstood risks imbedded in them. Bottom line: investors should look for the novel elements which may have a disproportionate impact on their result.

The brain is trained, perhaps from birth or womb, to quickly react to a number of stimuli. (Maybe that is what governments and their central bankers were trying to evoke by the use of their various stimuli.) As the brain is capable of learning, other control mechanisms can be added to the coded behaviors. Probably since the beginning of free markets investors have been evolving automatic responses to various market, political, military and economic news or rumors. These automated reactions are what are being used by computer-driven quantitative (“quant”) trading.  On the other side of that trade will be another quant with a different algorithm, an uninformed investor, an investor with a different time horizon or an investor with a different set of instincts. In the US Marine Corps a great deal of effort is expended in trying to develop instincts in young Marines that go beyond mere obedience to orders. Often when Marine point persons are leading their units, they do not know precisely what they are looking for, but instincts are to avoid the unexpected danger. Such was my brother’s task in the Korean War. In the same way some very successful investors see opportunities where others see risks, and much more valuable, see risks where others see opportunities. Both the quant and the instinctive investor are practicing self-control. The difference is when each periodically make mistakes the instinctive investor can use the brain as a learning device. Often the difference between various computer-driven strategies is only the time to make a decision and the time to act.  The quant moves as soon as the condition appears, the instinctive investor is at the same time patient and anticipatory.

Scientists say that the brain wants to dampen down uncertainty. The investor selectively wants to take advantage of uncertainty. Uncertainty creates the price amplitude on the charts. If there were no uncertainty there would be very little trading, just those who had current needs for cash or to change the focus of their portfolio.

Consequences of negative results to an experimenter can lead to abandoning a particular approach. To an investor, really bad results mean that the beneficiaries of this diminished portfolio will be forced to change their life’s plans. One might say that a scientist has career risk where for the investor and his/her clients there are risks to an accustomed way of life.

Reactions to weekend reading

The chase for income by investors has overrun caution. A year ago bonds rated CCC were yielding 11.5% and now 8.2%, which is probably the lowest yield for the average of these speculative bonds in many years.  The funds buying this paper are responding to significant in-flows of money by stressed investors hungry for yield. This is a dangerous sign.

We are in a recovery phase and getting close to our old highs. (Actually for a number of our accounts we are at new peak levels.) However, investors should understand the math of recoveries. A price jump of 114.6% for the average of five Asian stock markets excluding Japan sounds great. The price gain was after a fall from prior peak levels of 58.9%. However the recovery is not complete, as the rise brings prices not quite equal to the former peak. Be careful of performance records and advertising, as the poor performance of US markets in 2008 drops off in the five year numbers, the records will look similar to the Asian numbers. We have been urging investors to use ten year performance data as more representative of future results, and even they may not be that good.

Increasingly we are seeing stock prices pop up after layoff announcements. While saving on compensation and related expenses do help the bottom line, there are other effects. As we have seen in both the financial services and media communities, in addition to the planned layoffs some of the most skilled employees reassess their opportunities and loyalties and begin to look around or accept external feelers. As an analyst I prefer to see multi-product and multi-location employers decide to exit certain businesses and locations. They should be focusing on their companies’ strengths.

Does the Fed deserve to be independent?

As reported in several recent news articles, the Federal Reserve Board was not conscious of the seriousness of the sub-prime lending problem in 2007.  According to the Federal Reserve Board Chairman, the Fed did not have the tools to uncover the problem and still does not have the tools to spur the economy beyond what it is currently doing.  As the central bank of the United States, the Fed has moved away from its original 1913 mission, being the “bank of last resort,” focusing on the safety and soundness of the nation’s banks. The Fed has gone beyond its original mandate, (as with other nations’ central banks) to become an instrument of the government. If we are to recognize this new role of the Federal Reserve, then we should hold the government accountable for the economy.

The success rate of guerrilla forces

Often I have said investors should try and find disruptive companies. I should stress successful disruptive companies. Years ago addressing a brokerage industry conference I indicated that many of the larger members of the industry would be hurt by the guerrillas (not as some interpreted as gorillas).  In an article in Saturday’s Wall Street Journal, Max Boot examines the success rate of guerrilla forces against incumbent governments. Since 1775, the guerrilla has succeeded 25.2% of the time, and since 1945, 39.6%. This is not to say that the many of the policies of the guerrillas were not eventually adopted by the incumbent governments. But they did not directly benefit.

What are your reactions to these elements of input? Please let me know.
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