Sunday, January 17, 2016

Statistical Correlations are Costly


Why are most stocks down in the first two weeks of 2016 and far too many down in 2015? I submit that our brains are wired to use statistical comparisons rather than to accept uncertainty. Far too many of us learned about investing through academic institutions or pundits. Rarely do investment discussions go beyond the second sentence without relying on accounting terms and comparisons with popularly available indices or their derivatives. I suggest that we have gotten too far away from the early successful investors of merchants and farmers.

The “Modern” Investment Mind

In the pioneering work done at Caltech and other places on the motivations and actions of brain functions, scientists have discovered that different parts of the brain light up when dealing with fear and greed but essentially brains are memory devices. We store our own experiences and in some cases others. I believe what we store are the differences or deltas between the experiences and expectation.

This factoid is more easily stored than “we did better or worse than the “model” +100% or -50%.” This mechanism explains our need for comparative data. Bear in mind this is where the current state of the art is, but two quotes from Caltech suggests future refinements or changes.  A motto of the Jet Propulsion Laboratory (managed by Caltech) is: “Dare Mighty Things” and a quote from a Life Trustee Charles H. Townes, the only person to win both a Nobel Prize and a Templeton Prize, “The fundamental nature of exploration is that we don’t know what’s there. We can guess and hope and aim to find out certain things, but we have to expect surprises.”

Confession of an Index Maker

As someone who probably created more mutual fund indices than anyone, I know  something of the black art of creating indices for use by others. The critical building blocks were finding statistics already accepted by professionals individually and combine them to find a central tendency with a reasonable level of dispersion. For example, in a recent study to guess at future investment expectations, I was able to look at the various mutual fund sub-indices of funds in a client’s account for the last ten years.  The top two doubled over the 10 year period with annual gains of 7.52% and 7.30%. Perhaps more significantly was that an index of Balanced funds (owning stocks and bonds) gained only 5.43%. The significance of this finding is that as a US foundation with an IRS requirement to distribute at least 5% of its corpus, if inflation exceeded 0.43% a year the purchasing power of the foundation would decline and thus its grant making capability.

In a somewhat similar matter the popular securities indices were put together by publishers or brokers to capture the central tendencies of a market. There was no attempt to assemble a prudent portfolio for an individual or more significantly an institution to own. With that understanding I find that it is unsound to use these vehicles even in their index fund or ETF versions for fiduciary comparisons. With the majority always wanting to take the easiest comparisons not only are these indices being used as comparisons but also as correlation devices.

As bad as the general market indices are, what is worse is the sector/industry indices that are being used. The components of these indices are based on the principal products being sold as found in the US Government’s Standard Industrial Code (SIC). As an old specific industry security analyst, in numerous cases I found much greater differences in companies I covered rather than the products they sold. (Note I said sold rather than produced - either totally, white labeled or just assembled.) No wonder the stocks and bond prices for these entities move differently.

More Difficult to Define But Better

Believing that good analysts and portfolio managers are closer to artists than accountants, I think at any given time the single most critical element in wise selection is one of four attributes. While each of the four are almost always present from an investors’ standpoint, one or possibly two should be identified as the basis for comparison in building a properly diversified portfolio. Some of this thinking is parallel with Howard Marks of Oaktree Capital, whose latest thoughtful letter I will discuss below.

The four critical elements are: Supply, Demand, Time and Talent. The use of a firm’s capital to address the needs for expanded supply or increased demand is of particular interest to Marathon Asset Management in London who in a recent study identifies where in a capital commitment cycle a firm is. In an initial stage often the market will absorb all the supply that is available, be it in raw materials or semiconductors. That is until supply overcomes demand and then the critical focus is generating sufficient demand at reasonable prices. With many new product/services companies their initial focus is creating demand in the first place. Often this is the first business need for intellectual property companies.

The third critical element is Time. This needs to be looked at from both the producer and investor standpoints. From a producer’s position the time to produce and deliver is a competitive challenge. The first to be able to deliver in quantity and appropriate price will command the market as long as this condition lasts. From an investor’s viewpoint time issues involve average expected holding periods, payments to wait, expected terminal prices, and possibly certain critical performance dates.

The fourth critical element is talent management throughout the organization. This is critical regardless of size and it starts with the top but also includes, developers, client-facing staff and appropriate control and regulatory elements. The absence of a working plan to secure all of these creates substantial risk for the investor and in the long run for the employees and customers.

While I have yet to see funds or managers show their portfolios in terms of these four elements, some of the smarter ones can and do discuss their portfolios this way. To me this approach allows me to be a longer term holder of their portfolios.

During the kind of decline we are currently experiencing, I am seeing too much cross correlations with stocks in multiple industries, but very similar investment characteristics. Thus, in effect they have become a singular investment which we can use by providing our own diversification by marrying the questioned portfolio with other managers or funds. However, we would have to reject the singular focused fund as not appropriately diversified for some accounts.

Bullets from Howard Marks' Paraphrased Wisdom

Howard’s latest letter is over twenty pages. Below are brief thoughts from his letter:

1. In order to be a successful investor you need to understand psychology.
2. Strike a balance between offense and defense strategies. (single teams)
3. Too many overlook negatives until they capitulate.
4. Daily markets are a barometer of sentiments.
5. Perceptions swing from flawless to hopeless. (Apple?)
6. Investors know less than they thought.
7. There is false belief in investors’ rationality and objectivity.
8. Expectations should be included in transaction prices.
9. Illiquid assets + capital flight = investment disaster.
10. Markets move from yield focus to recovery potential.

Question of the Week: Would you like to discuss any of the points mentioned?
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A. Michael Lipper, CFA,
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