Boundedly Rational Investing

I often get asked about the meaning of “bounded rationality”, and how it relates to investing. This post will examine both the definition and relevance of this concept.

Bounded rationality is based on the premise that an individual’s rationality is limited by both his cognitive ability and environment: the purely rational economic man does not exist. Herbert Simon coined the term in 1955, and used the metaphor of a pair of scissors, where one blade is the “cognitive limitations” of actual humans, and the other the “structure of the environment”.  According to Simon, studying one blade is not enough: it takes both for the scissors to cut. Minds with limited time, knowledge, and other resources can be successful by exploiting structures in their environments (Selten).

“Boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information. A great deal can be learned about rational decision making, by taking account of the fact that the environments to which it must adapt possess properties that permit further simplification of its choice mechanisms.”

In complex environments (such as the stock market), we can say that humans are not “unboundedly rational” but “boundedly rational”: they must “satisfice” to the best of their ability. Understanding limitations, and being aware of the biases and heuristics that can affect decision making, is extremely important to success. In truth, this lies somewhere between cognitive and ecological rationality, governed by simple and straightforward heuristics, which are often context dependent. There needs to be a balance, because using too few heuristics often leads to biases and sub-optimal decisions (Kahneman and Tversky), whilst the use of too many can often lead to confusion (Gilovich).

An illustrative example could be of some help here. Imagine we wanted to predict how an expert billiards player would hit a certain shot. We would measure the angles and distances, get the coefficients of elasticity of the balls and the bumpers, and we would solve a set of differential equations. But is that how the billiards player figures out what to do? I’m not so sure. We don’t know exactly what he would do, but surely optimization theory is not the most efficient way of figuring this out; the “fast and frugal heuristic” actually used by the billiards player would be much more useful.

Simon recommended that individuals think this way in order to make the most effective decisions in a given situation (that is, those with the highest expected value). He also recommended rethinking the norms as well as studying the actual behavior of minds and institutions. It is a multi-disciplinary concept, not unlike Charlie Munger’s idea of “multiple mental models”. Gigerenzer points out three distinct processes that these models specify:

• Simple Search Rules
• Simple Stopping Rules
• Simple Decision Rules

Using these rules as a foundation, individuals must develop an “adaptive toolbox” to deal with different problems in different circumstances – this is where the idea becomes relevant to investors. There are so many companies, with so many variables, that considering them all would be impossible, and considering every possible valuation metric would be quite confusing. Investors must learn to develop guiding principles, both for their selection procession and for their behavioral actions, when investing; they must try to act as rationally as is necessary, but no more. “It is the mark of an educated mind to rest satisfied with the degree of precision which the nature of the subject admits and not to seek exactness where only an approximation is possible.” ~ Aristotle.

Boundedly Rational Investing involves beginning with a simple and straightforward screening process, made up of 10 to 15 points, in both company analysis and individual behavior. It then involves shifting through masses of information and focusing on the few key elements which make a difference for the company in question (keep in mind, for instance, that all financial ratios are not relevant for all companies – adaptability is key). When analyzing a company, we are often dealing with the future, and therefore, with numerous assumptions. Starting with some checklist style tools – à la Charlie Munger – can help achieve a certain amount of clarity, which I  believe is necessary.

To help you get started, I have pointed out heuristics used by some great investors; think of them as tools for the adaptive tool box. By checking them repeatedly, investors should be able to act in a sufficiently rational way when making their investments, which should greatly improve their chances of success. Although the purely rational man does not exist in complex environments, the sufficiently rational man does.

When considering this “simplistic” approach, be aware that it is mainly a learning framework to help build an appropriate process. It should be combined with significant personal study and analysis to become most affective: investing can be simple, but not easy.

Warren Buffet:

“We selected investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business:

• Favorable long-term economic characteristics
• Competent management
• Purchase price attractive when measured against the yardstick of value to a private owner
• An industry with which we are familiar and whose long-term business characteristics we feel competent to judge”

Seth Klarman:

“We look for good businesses with:

• strong barriers to entry
• limited capital requirements
• reliable customers
• low risk of technological obsolescence
• abundant growth possibilities
• and thus significant and growing free cash flow”

Francis Chou:

“The investments that have proven most successful for us include:

• Above-average to excellent companies as measured by high ROE in excess of 15% sustained over 10 years or more.
• Companies run by skillful managers as measured by good controls maintained on receivables, inventory and fixed assets.
• Prudent deployment of capital as measured by a company’s capital expenditures, judicious acquisitions, and timely buybacks of its depressed shares.
• A stock price which is far lower than what a knowledgeable and rational buyer would pay.”

William Ackman:

“We seek simple, predictable, free-cash-flow-generative businesses that trade at a large discount to intrinsic value:

• Mid and large-cap companies
• Typically not controlled
• Minimal capital markets dependency
• Typically low financial leverage and most economic sensitivity
• Often hidden value asset base
• Catalyst for value creation which we can often effectuate

At the right price, we may waive one or more of the above criteria. Our selection process is designed to help avoid permanent loss of capital while generating attractive long-term returns.

Our concentrated portfolio has many advantages:

• Best idea fund (we invest in our 8 to 12 best ideas; we are always willing to replace an existing holding for a better opportunity)
• Provides transparency to our investors (few investments + detailed disclosure)
• Simplicity (we need only a handful of new ideas per year)

David Einhorn:

“Our portfolio discipline is to construct our portfolio from the bottom up.  As value investors, we take long positions in good companies that we believe have clean and unlevered, or minimally levered, balance sheets and have misunderstood prospects.  Of course, should the economy weaken they may earn less than they would in a strong or normal economy, but we believe that a lot of bad news is baked into their valuations and that these companies will survive the cycle.  On the other hand, we are short companies that have significant problems of various sorts:  some have bad business practices or have played accounting tricks; others trade at very high multiples of earnings expectations that are unlikely to be achieved; while others have flawed business models and are unlikely to be long-term survivors.  We believe that over time, this is a sensible way to invest and will prove to be a lucrative portfolio construction methodology.  Our investment strategy has always reflected time arbitrage in that we position ourselves to benefit from having a significantly longer-term horizon than other market participants.”

“There seems to be some perverse human characteristic that likes to make easy things difficult.” Warren Buffet

Note: This is a repost of an essay I wrote around a year ago, which various readers have asked me about.

Links 16/08/2010

• Old School Value Review
• Old School Value Forbes Small Companies Analysis
• Old School Value DCF
• Focus Investor on Mental Models
• Peter Bevelin Interview
• Lesson on Expected Value
• The Insolvency of the Fed
• Morningstar vs. Old School Value

Household Balance Sheets

Recently, I’ve noticed various financial commentators speaking about the household balance sheet. In my opinion, it seems as though there are quite a few errors in reasoning, especially with regards to debt. I don’t have time to examine all of them, so I will address the important ones. My initial comment regards the use of the term “net debt”, as I don’t think it’s appropriate when examining the household balance sheet. Net debt, in a microeconomic sense, is defined as short term debt + long term debt – cash & cash equivalents. When examining the household balance sheet, calculating such a number would be extremely difficult, as determining “cash equivalents” would be ambiguous, at best. Is one to include pension funds in such a number? They are, after all, quite illiquid, depending on your age. And even so, the number would almost never be positive, making the debt seem irrelevant. But let us not forget that non-cash asset values can be dubious and subjective, whilst debt can not. It must be serviced, and the measure of the ability to service this debt, depending on maturity, is usually based on elements such as short term assets and earnings, amongst others (this is true for both companies and households). Most established economists use total debt as a percentage of disposable income as a benchmark for this reason. And by this measure, U.S. households still have a lot of deleveraging to do. As of the end of 2009, total household debt stood at 122.5% of annual disposable income, down only marginally from a peak of 130.6% at the beginning of 2008 (Economists tend to see 100% as a sustainable level).

Many comments on household net worth seem to be used improperly. One must examine how household net worth is measured, and question the reliability of asset values on the household’s balance sheet. The alarming aspect of the situation is the trend of debt vs. assets or income, as well as the shift in type of assets (towards riskier assets). Ken Rogoff is, for the most part, worried about this trend, and with good reason. Allow me to demonstrate my analysis.

Based on recent (2009) Flow of Funds Statistics, US household net worth was roughly $54 trillion. Assets stood at roughly $68 trillion – made up of $45 trillion in financial assets and $23 trillion in tangible assets. Liabilities stood at roughly $14 trillion. Of the $45 trillion in financial assets, roughly $30 trillion were in the form of equities or equity equivalents, including corporate equities, mutual funds, equity in non corporate businesses, pension funds etc. Roughly $8 trillion were held in credit market instruments, including open market paper, treasuries and corporate and foreign bonds. Only $7 trillion were held in deposits, which includes currency, checkable deposits, money market funds etc. In 1980, based on Flow of Funds Statistics, US household net worth was roughly $10 trillion. Assets stood at roughly $11,4 trillion – made up of $6.5 trillion in financial assets and $4,9 trillion in tangible assets. Liabilities stood at roughly $1,4 trillion. Of the $6,5 trillion in financial assets, $4 trillion were held in equity or equity equivalents; roughly $1 trillion in credit market instruments, and $1,5 trillion in deposits.

Multiple conclusions can be drawn from this brief analysis. First, we notice that whilst assets have increased by a factor of 6, liabilities have increased by a factor of 10. Further analysis indicates that, in the 1970 and 1980s, consumer credit was in majority made up of non-revolving credit, to the tune of almost 98%. Today, non revolving credit is only 70% of consumer credit. This means, simply, that 30% of total consumer credit will become much more expensive to service should interest rates rise. Additionally, we can see that whilst, in 1980, roughly 40% of total assets were tangible, in 2009, this had dropped to 29%. Equities, or equity equivalents, increased to roughly 50% of the total, up from 35% in 1980. The conclusion from this analysis is simple: the average US household has shifted towards riskier assets, and has, on average, increased debt more rapidly than assets (and assets were increasing at unsustainable rates). As is the case with all balance sheet analysis, we must examine the quality of the assets in order to estimate the validity and sustainability of NAV.

Why is this worrisome? Currently, most of household “wealth”, and the increase in this wealth, is made up of financial assets. Between 1982 and 1999, the large general rise was largely due to the unprecedented rise in capital markets – mostly equities; from 1999 to 2007, the rise in household assets was largely due to an unprecedented rise in home prices. Both of the rises were far beyond what fundamentals indicated. In short, much of the rise in household wealth over the past 30 years seems to be the result of various asset bubbles, none of which are sustainable over long periods. Individuals who believe that the markets, whether capital or real estate, will move back into long term parabolic rising phases right away may be disappointed (especially in real, inflation adjusted, terms). And whilst the asset values of US households are only a partial measure of actual real wealth, the debt of households is very real, and has been rising at alarming rates. In truth, total US household debt, including both consumer and mortgage debt, has increased from roughly $1,4 trillion in 1980, to $14 trillion in 2009. Often, the trend is just as, if not more, important than absolute change. Recent arguments are similar to those of CNBC pundits in 2005 and 2006. They pointed out that the debt was manageable because Americans had so many “assets”. Only a small number of economists (Marc Faber, Robert Shiller and others), pointed out that the value of those asset was illusionary. Many thought they had enormous amounts of wealth, but it was “unrealized wealth”, and once the bubbles burst, and asset prices came down, it would become obvious that their levels of debt were unmanageable. Now, as was the case in 2002, a pro-stimulus and low interest rate environment has caused another large rise is capital markets, and once again, individuals make the same mistake of assuming that everything is back to pre-crisis norms, and debt is completely manageable again. What if growth doesn’t return to those levels? What if, once the effect of corporate cost cutting wears off, top line doesn’t follow, leading to sub-2007 earnings? What if interest rates begin to rise in a dramatic manner at some point over the next 3-5 years? Intelligent investors are, by nature, skeptical. They focus on downside potential first.

There’s nothing inherently wrong with increasing exposure to riskier assets, as long as downside is taken into account via provisions. The alarming decline in savings over the past two decades, in conjunction with increase in general levels of debt, is the issue in question. It leaves the average household with very little wiggle room, and forces them into a difficult situation (forced selling of financial assets; restrained consumption etc.) in order to service their increasing debt when things go wrong. Real wealth, sustainable wealth, should come in majority from more sustainable means, such as income (whether work or investment related), not increases in paper assets like stocks. US household nominal income has increased by a factor of 2-3 times (depending on the demographic) since the early 1980s (only 35% in real inflation adjusted terms http://www.census.gov/hhes/www/incom…inc/h06ar.html). When we examine this next to debt increases, the the situation cannot be ignored. It paints a clear picture of how US households finance their consumption, and seemingly increasing standards of living.

Even after the crisis, the majority of household debt is still there, whilst interest rates have hit generational lows. These are, by all measures, unsustainable. As interest rates begin to rise, so too will the servicing costs of revolving household debt. From a historical perspective, US household debt as a percentage of assets is too high, debt service ratios are too high and household debt as a percentage of GDP is too high. Rogoff’s point, which is valid, is that the consumer has hardly de-leveraged since the start of the crisis, and must do so. This Balance Sheet recession will likely lead to anemic growth in the economy for some time. As the US household continues to de-leverage, the Keynesian system assures that the government will have to continue to run a budgetary deficit or a trade deficit, or both. In any event, the outcome is not a positive one for the US as this will, in fact, shift the problem from the consumer balance sheet to the government balance sheet, creating what could be another asset bubble, potentially in government securities. Of course, nobody is saying that the US will default on these obligations, instead, it will likely “print money” to attempt to resolve the situation, the result of which will be much higher price and/or asset inflation (I’ve noted before that I’m not yet a believer in the hyperinflation scenario based on current evidence). It was able to avoid this over the past 20 years as a result of a different method of financing government debt: deficit finance bonds sold to private investors through existing financial markets. This placed the bonds in the hands of investment funds, or foreign central banks, rather than on the books of commercial banks as would have been the case had they returned to the old style of monetization. The result was asset price inflation as opposed to price inflation. This may not be the case going forward.

In sum, these are the reason why Rogoff, and many other economists, are nervous going forward. I believe them to be justified, as evidenced by the points above.

Also, please note that we are not including the national debt as a liability when calculating household net worth. As such it becomes an off balance sheet liability for households; that is definitely not the proper way to account for it.

If you have any questions, let me know.

Thanks

eboro

Sources:
U.S. Federal Reserve – Flow of Funds report
U.S. Census Bureau
U.S. Treasury – Bureau of the Public Debt

Process vs. Outcome

“Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision making can be encouraged by evaluating decisions on how well they were made rather than on outcome” – Robert Rubin

Given Rubin’s recent retirement from Citigroup, I thought this quote was appropriate. Research by Russo and Schoemaker has identified  a common trait amongst successful performers in probabilistic fields: they all emphasize process over outcome. Similarly, investors should try to judge decisions on how they were made instead of on the results they engender.

This is not to say that results don’t matter; obviously they are extremely important in measuring success. That being said, it seems as though many investors  don’t realize that certain positive outcomes, even strung together in successive numbers, are simply part of normal probabilistic distribution. Some believe that because they were able to select winning stocks consecutively, or have 2 consecutive high return years, they possess large amounts of skill. Often, investors fail to examine why they were winners because they are too busy recounting their successes. Remember, “All people are most credulous when they are most happy” – Walter Bagehot. By examining why an investment was (or was not) successful, you can reduce these inherent biases which cloud judgment.

I would recommend looking at fundamentals of valuation rather than stock price. Do not make the mistake of thinking that because the investment worked out, your analysis must have been correct (or vice versa). A perfect example is the internet bubble of the late 90s; many hedge funds believed they had inordinate amounts of skill, when in reality their success was the result of an extreme bull market combined with the human fallacy of hoarding and false expectations. The famous Wall Street adage goes: “Don’t confuse brains with a bull market”. When the bubble burst, they quickly saw that the skill they thought they had was in fact illusionary.

Here are Rubin’s four principles for decision making, which should provide a good basis for thinking about this:

• The only certainty is that there is no certainty: We need to train ourselves to consider a sufficiently wide range of outcomes.

• Decisions are a matter of weighing probabilities: We must realize that some high-probability propositions are unattractive, and some low-probability propositions are very attractive on an expected-value basis.

• Despite uncertainty, we must act: the point here is that we must base the majority of our decisions on imperfect or incomplete information. We must make such decisions based on an intelligent appraisal of available information.

• Judge decisions not only on results, but also on how they were made: A good process is one that carefully considers price against expected value.

The Self-Awareness Paradigm

“We know well that mistakes are more easily detected in the works of others than in one’s own. When you are painting you should take a flat mirror and often look at your work within it, and it will then be seen in reserve, and will appear to be by the hand of some other master, you will be better able to judge of its faults than in any other way” – Leonardo Da Vinci

It is important, in both investing and in life, to try to stand apart from yourself. Some call it “meta-cognition”, but most simply refer to it as “self-awareness”. It is the ability to think about your very thought process, and examine it as if from a third party’s perspective – unbiased. Stephen Covey points out that this ability explains why man has dominion over all things in the world, and why he can make significant advances from generation to generation: “This is why we can evaluate and learn from others’ experiences as well as our own. This is also why we can make and break our habits”. Making good habits, and breaking bad ones, is essential to long term success; in my view, the process starts with the awareness of common biases. The ability to act without bias is one of the hardest parts of investing – as they often lead to misjudgments and errors, of which we only become aware in hindsight (if at all).

For this reason, it is best to be pro-active and not reactive. This is to say that people often view evidence as supporting their beliefs, instead of examining all of the facts objectively, and actively. I would recommend approaching every idea tentatively, and always looking for disconfirming evidence. When examining a company for investment purposes, Warren Buffet recommends avoiding the market price, initially. Instead, one should examine the facts without any preconceptions, and come to a rational conclusion about the value of the business. Once you’ve put a price on the whole business, using the annual report, then compare it to the market price. By using this method, you will not begin your research with any pre-conceived notions, and you will certainly not be subconsciously “confirming” a thesis. Remember that human beings are best at interpreting all new information so that their prior conclusions remain intact.

“If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubts, he shall end in certainties.” ~ Francis Bacon

Note: How am I to find an interesting company without screening for low prices? You can start by using screens such as Joel Greenblatt’s, or simply examining 13-Fs. Just make sure to begin with doubts.

Warren Buffet Speech to Florida Graduates

Another great talk, this time by Mr. Buffet. I have highlighted one of my favourite passages below.

Your Future

I would like to talk for just one minute to the students about your future when you leave here. Because you will learn a tremendous amount about investments, you all have the ability to do well; you all have the IQ to do well. You all have the energy and initiative to do well or you wouldn’t be here. Most of you will succeed in meeting your aspirations.

But in determining whether you succeed there is more to it than intellect and energy. I would like to talk just a second about that. In fact, there was a guy, Pete Kiewit in Omaha, who used to say, he looked for three things in hiring people: integrity, intelligence and energy. And he said if the person did not have the first two, the later two would kill him, because if they don’t have integrity, you want them dumb and lazy.

We want to talk about the first two because we know you have the last two. You are all second-year MBA students, so you have gotten to know your classmates. Think for a moment that I granted you the right–you can buy 10% of one of your classmate’s earnings for the rest of their lifetime. You can’t pick someone with a rich father; you have to pick someone who is going to do it on his or her own merit. And I gave you an hour to think about it.

Will you give them an IQ test and pick the one with the highest IQ? I doubt it. Will you pick the one with the best grades? The most energetic? You will start looking for qualitative factors, in addition to (the quantitative) because everyone has enough brains and energy. You would probably pick the one you responded the best to, the one who has the leadership qualities, the one who is able to get other people to carry out their interests. That would be the person who is generous, honest and who gave credit to other people for their own ideas. All types of qualities. Whomever you admire the most in the class. Then I would throw in a hooker. In addition to this person you had to go short one of your classmates.

That is more fun. Who do I want to go short? You wouldn’t pick the person with the lowest IQ, you would think about the person who turned you off, the person who is egotistical, who is greedy, who cuts corners, who is slightly dishonest.

As you look at those qualities on the left and right hand side, there is one interesting thing about them, it is not the ability to throw a football 60 yards, it is not the ability the run the 100 yard dash in 9.3 seconds, it is not being the best looking person in the class, they are all qualities that if you really want to have the ones on the left hand side, you can have them.

They are qualities of behavior, temperament, character that are achievable, they are not forbidden to anybody in this group. And if you look at the qualities on the right hand side the ones that turn you off in other people, there is not a quality there that you have to have. You can get rid of it. You can get rid of it a lot easier at your age than at my age, because most behaviors are habitual. The chains of habit are too light to be felt until they are too heavy to be broken.

There is no question about it. I see people with these self-destructive behavior patterns at my age or even twenty years younger and they really are entrapped by them. They go around and do things that turn off other people right and left. They don’t need to be that way but by a certain point they get so they can hardly change it. But at your age you can have any habits, any patterns of behavior that you wish. It is simply a question of which you decide.

If you did this… Ben Graham looked around at the people he admired and Ben Franklin did this before him. Ben Graham did this in his low teens and he looked around at the people he admired and he said, “I want to be admired, so why don’t I behave like them?”. And he found out that there was nothing impossible about behaving like them. Similarly he did the same thing on the reverse side in terms of getting rid of those qualities. I would suggest is that if you write those qualities down and think about them a while and make them habitual, you will be the one you want to buy 10% of when you are all through. And the beauty of it is that you already own 100% of yourself and you are stuck with it. So you might as well be that person, that somebody else.

Question: What makes a company something that you like?

Buffett: I like businesses that I can understand. Let’s start with that.  That narrows it down by 90%.  There are all types of things I don’t understand, but fortunately, there is enough I do understand. You have this big wide world out there and almost every company is publicly owned. So you have all American business practically available to you.  So it makes sense to go with things you can understand.  I can understand this, anyone can understand this (Buffett holds up a bottle of Coca- Cola).  Since 1886, it is a simple business, but it is not an easy business—I don’t want an easy business for competitors.  I want a business with a moat around it.  I want a very valuable castle in the middle and then I want the Duke who is in charge of that castle to be very honest and hard working and able. Then I want a moat around that castle.  The moat can be various things: The moat around our auto insurance business, Geico, is low cost.

So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about in a general way where they will be ten (10) years from now.  If I can’t see where they will be ten years from now, I don’t want to buy it. Basically, I don’t want to buy any stock where if they close the NYSE tomorrow for five years, I won’t be happy owning it.  I buy a farm and I don’t get a quote on it for five years and I am happy if the farm does OK.  I buy an apartment house and don’t get a quote on it for five years, I am happy if the apartment house produces the returns that I expect. People buy a stock and they look at the price next morning and they decide to see if they are doing well or not doing well.  It is crazy.  They are buying a piece of the business.  That is what Graham—the most fundamental part of what he taught me.

Question: Why do large caps outperform small caps (1998)?

Buffett: We don’t care if a company is large cap, small cap, middle cap, micro cap.  It doesn’t make any difference.  The only questions that matter to us:

• Do we understand the business?

• Do we like the people running it?

• And does it sell for a price that is attractive?

Benjamin Franklin on Value

“The Whistle”

“…We should draw all the good we can from this world. In my opinion we might all draw more good from it than we do, and suffer less evil, if we would take care not to give too much for whistles. For to me it seems that most of the unhappy people we meet with are become so by neglect of that caution….

When I was a child of seven years old, my friends, on a holiday, filled my pocket with coppers. I went directly to a shop where they sold toys for children; and being charmed with the sound of a whistle, that I met by the way in the hands of another boy, I voluntarily offered and gave all my money for one. I then came home, and went whistling all over the house, much pleased with my whistle, but disturbing all the family. My brothers, and sisters, and cousins, understanding the bargain I had made, told me I had given four times as much for it as it was worth; put me in mind what good things I might have bought with the rest of the money; and laughed at me so much for my folly, that I cried with vexation; and the reflection gave me more chagrin than the whistle gave me pleasure.

This, however, was afterwards of use to me, the impression continuing on my mind; so that often, when I was tempted to buy some unnecessary thing, I said to myself, Don’t give too much for the whistle; and I saved my money.

As I grew up, came into the world, and observed the actions of men, I thought I met with many, very many, who gave too much for the whistle….

If I see one fond of appearance, or fine clothes, fine houses, fine furniture, fine equipages, all above his fortune, for which he contracts debts, and ends his career in a prison, “Alas!” say I, “he has paid dear, very dear, for his whistle….”

In short, I conceive that great part of the miseries of mankind are brought upon them by the false estimates they have made of the value of things, and by their giving too much for their whistles.”

Change

“Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.” ~ John Kenneth Galbraith

The ability to change or adapt one’s strategy is extremely important in investing. Warren Buffet started out as a “Cigar Butt” investor, à la Benjamin Graham. Although it took over a decade, he gradually changed his strategy, and began focusing on the qualitative aspects of businesses such as management, competitive advantage etc. This is not to say that he pays no attention to intrinsic value anymore; he simply tries to buy great companies at very attractive prices.

I’ve noticed recently that various famed value investors have evolved in their investments. In a recent article, Whitney Tilson stated:

“I’ve come to a somewhat similar conclusion with respect to paying more attention to macro considerations in individual stock selection and overall portfolio positioning. Like many dyed-in-the-wool value investors, I have traditionally left macroeconomic or political forecasting to the pundits and focused almost exclusively on individual, bottom-up stock selection.”

Mohnish Pabrai, another famed value investor, has also evolved and rethought his strategy:

“There is a lot to be said for running a concentrated portfolio. Good investing ideas are scarce. It is very hard to find dozens of them. Also, as Buffett says, why would you invest money in your 30th best idea versus investing more in your very best idea? And Charlie Munger is on record stating that a well diversified portfolio can be constructed with just four positions.” Before continuing “One needs to be a learning machine and be willing to give up some of our best loved ideas when the evidence suggests they are flawed. Going forward, to temper volatility, Pabrai Funds will endeavor to size positions at 2%, 5% or 10% of assets. For new positions the norm will be a 5% investment. Stocks that strongly correlate (that is move in lock-step with one another) will be sized at 2% and once every few years positions will be up to 10% of holdings.”

Evidently, Tilson has changed his analytic strategy and Pabrai has changed his allocation policy. There is much to be said about investors who manage to overcome biases such as “rationalization”, “overconfidence”, “anchoring” and “confirmation”, and change their investment strategies to improve their results. These investors, like Buffet, are the most likely to find continued success. “When the facts change, I change my mind. What do you do sir?” JM Keynes

Note: The idea for this post is from Noise Free Investing,  an excellent blog, which I would recommend reading (link).

Soon

Hello All,

I apologize for the lack of posts over the past month; work has been extremely busy. That being said, I’ve spent a lot of time preparing my  next post, which I hope everyone will enjoy. More to come, soon.

Mr. Kneale

My investment post will have to wait. The reason, I’m afraid, is Mr. Dennis Kneale.

A few days go, this CNBC news anchor, made a statement to the effect that the recession was over, and that the worst was far behind us: better times are here, and people should embrace “the hope”. Although this blog rarely criticises individuals outright, I felt strongly about writing a piece proposing a response to Kneale’s statement. I’m not predicting a continuation – or end – of the recession, I’m simply pointing out that investors should be cautious, especially since the markets have rallied over 40% in only 3 months.

In his recent segment entitled: “The Recession is Over”, Kneale examins recent data, and points out the bullish implications for both the economy and the stock market. However, for someone who often criticises his opposition for lacking hard evidence to backup their claims, Kneale has very few tangible  facts – and uses the ones  he has in an extremely biased and misleading way (imho). His “pile of data” includes only 4 indicators, many of which are lagging. Oddly enough, he doesn’t mention a single indicator that the NBER (National Bureau of Economic Research) uses when examining recessions; he goes on to talk about Durable Goods, Capital Goods, Stocks and Consumer Sentiment.

Firstly, increases in Durable and Capital Goods orders are perfectly normal in this type of situation, and do not signal the comming “party” Kneale describes. It is a matter of inventories: businesses decided they had too much “stuff” in warehouses, so they slashed production well below final sales. Correspondingly, what we’re seeing is likely the result of the end of this de-stocking process, and start of a “re-stocking” one. Interestingly, both of these indicators describe business spending metrics, and not consumer spending metrics. Given that US GDP, in terms of aggregate demand, is approximately 70% consumption based, it would have been more appropriate to discuss consumer spending, or retail sales.

What about consumer sentiment? Often, in the past, in has been made clear that consumer sentiment is not a consistent and valid measure of future economic and business activity. Further more, it is extremely fickle; for instance, in late 2007, consumer sentiment was almost at an all time high, right before the economy began its largest recession in 70 years. Also, given the massive amount of consumer debt, decline in real wages, unemployment etc., even if consumers do feel better about the economy, can they actually afford to spend meaningfully? (where are they going to get the money to spend?)

Then there is the question of the stock market, which has rallied 40% from the lows. We must remember that the stock market is a discounting mechanism, and “prices future events in”. At this point, the market is clearly pricing in a sustainable V shaped recovery. If this does not come to be, we can expect this “indicator” to decline heavily.

In my opinion, Mr. Kneale has succumbed to some of the investment field’s most common biases: confirmation bias (the tendency to search for or interpret information in a way that confirms one’s preconceptions) and expectations bias (the tendency for experimenters to believe, certify, and publish data that agrees with their expectations for the outcome of an experiment). Also, he conveniantly shows data month to month, and only for the past few months, thus neglecting to show that the recent increases are very small relative to previous levels – and the large declines throughout 2008-2009. As an example, if a company’s earnings decline from $1 billion per year to $100 million, and then rise to $140 million, I would call that improvement. If I showed an investor the past few months of data, showing a 40% increase in earnings, he would probably be excited; that is, as long as I didn’t show him the prior year’s levels and decline. This, in effect, is what Kneale has done with his data, limiting it to the past few months. It is  essential that an investor examine data on longer timeframes, to get a more accurate picture. Mr. Kneale has, in fact, manipulated his audience via this extremely short term picture.

Investors should try to be as unbiased as possible when examining data, by using the most commonly accepted indicators for particular circumstances. As Mr. Kneale focused only on recent data, most of which is less relevant than those I am about to discuss, I will also use a shorter term timeframe (the longer term would require much more time, and would only serve to paint an even more dire picture. Let’s try to stay somewhat “positive”).

So, what data is mostly commonly used for measuring recessions?  The NBER uses 5 metrics:

• GDP
• Industrial Production and Capacity Utilization
• Retail/Wholesale Sales
• Real Earnings
• Employment Situation
  

Let me start by briefly describing each of these, and why they are extremely relevant in determining the future state of the economy.

• GDP: This is one of the most important indicators of all, and is released quarterly. The gross domestic product (GDP) is a basic measure of an economy’s economic performance, it is the market value of all final goods and services made within the borders of a nation in a year. The source is the BEA and the report is released at the end of the quarter (3 month period). Link

• Industrial Production and Capacity Utilization: A very important indicator which often has an effect on the market. It is a measure of the change in production of the nation’s factories, mines and utilities. It also includes a measure of their industrial capacity and how much of it is being used (commonly known as capacity utilization). The level of industrial production divided by the level of industrial capacity equals the capacity utilization rate. The headline numbers are the percent change in production from the prior moth and the capacity utilization rate. The source is the Federal Reserve and the resport is released in the middle of the following month, around the 15th. Link

• Wholesale Survey: The first report of the month on consumer spending; capable of big surprises. Consumer spending makes up 70% of all economic activity in the US, and retail sales account for around 1/3rd of that. If consumers can keep cash registers ringing, it is a sign of overall economic growth and prosperity. Retails sales has some shortcoming though; it represents only spending on goods, such as those found at department stores, gas stations, and food service providers such as restaurants. The report tells us nothing about what’s being spent on services such as air travel, dental care, insurance etc. Also, retail sales is measured only in nominal dollars, which means that no adjustment is made for inflation. It is computed using surveys sent out randomly to 5000 large and small retailers around the country. The government receives a certain percentage back and releases an advanced report. Another 8000 retailers are surveyed a few days later, and a revised report is released, usually four weeks later. Wholesale numbers are, for the reasons described above, a better metric, and are used by the NBER. The source is the Bureau of the Census, Department of Commerce. The report is released about two weeks after the month ends. Link

• Real Earnings: This indicator represents real income. Data on average weekly earnings are collected from the payroll reports of private nonfar establishments. Earnings of both full-time and part-time workers holding production or nonsupervisory jobs are included. Real average weekly earnings are calculated by adjusting earnings in current dollars for changes in the CPI-W. The source is the Bureau of Labor Statistics. It is released mid-month. Link

• Employment Situation Report: The most eagerly awaited news on the economy, which measures if jobs are being created and the situation of American workers. It has great economic and political significance for various reasons: the more workers there are and the more they earn, the more they can buy and propel the economy forward. The report is rich in detail about the job market and household earnings, both of which are drivers of economic growth. It is computed using the Household Survey and the Establishment Survey. The source is the Bureau of Labor Statistics, Department of Labour. The report is usually released the first Friday of every month. Link

Now that we know what each of these is, let’s examine the most recent data in each category (the June reports have not all been released as of right now. I will update the post when them become available):

• GDP: decrease at an annual rate of 5.5% in Q1
• Industrial Production: decrease of 1.1% in May (capacity utilization dwn. to 68%)
• Wholesale Sales: decrease of 0.4% in May
• Real Earnings: decrease of 0.3% in May
• Employment: Unemployment increased to 9.5% in June (with non-farm payroll cuts at 475k, compared to the 350k estimate)

Simply put, none of the 5 indicators used by the NBER point towards an imminent recovery, or the “end of the recession”. Now, it must be said that some are declining at a lower pace, however, they are still declining; until they begin to rise, we must be very cautious about the so-called recovery. Above all, we must avoid making brash statements with carefully selected and less than relevant data (Mr. Kneale). And even if the indicators do recover, it must be noted that the recovery will likely be due in large part to government stimulus, and should therefore be viewed with skepticism. It’s entirely plausible that we could see 2-3% growth in early 2010, before the stimulus wears off. Balance sheet recessions are drawn out processes, which often see brief recoveries followed by further economic stress – think Japan in the 1990s.

I’d like to talk, briefly, about recessions, as there are in fact different types. As described recently by Karl Denninger, the types of recessions are inventory driven recessions, the most common, and credit driven recessions.

“Inventory-driven recessions are primarily about excessive industrial capacity for demand.  That is, manufacturers and suppliers of services get too bullish about prospects, build too much capacity and inventory, and wind up engaging in a destructive price war in an attempt to “win”.  This drives down profits and ultimately forces the weaker firms out of business, ergo, recession – GDP and employment decline.  Having cleansed itself of the excess, the economy recovers.   The trigger for these recessions is often (but not always) an external shock such as the oil embargo in the 1970s or the collapse of the Internet fraud-and-circuses games in 2000.

The second sort of recession is a credit-driven recession.  Excessive credit creation – that is, loans going too far toward “fog a mirror” qualifications (and in some cases, such as the most recent event, actually reaching “fog a mirror”) drives one or more asset bubbles.  These pop when effective interest rates in the economy reach an effective level of zero, usually because the amount of leverage available becomes for all intents and purposes infinite (Bear and Lehman at 30:1, Fannie/Freddie at 80:1, AIG at god-knows-what, and duped “home buyers” buying with zero down for a true infinite leverage ratio.)  This excessive credit creation drives a speculative asset bidding war which in turn causes prices to go sky-high for one or more types of asset.

The latter sort of recession is triggered because the cost of borrowing money is never actually zero, even if people pretend that it might be.  As a consequence the lenders begin to earn a negative spread and lose actual purchasing power.  This is an unsustainable situation because cash flow cannot be fudged nor can anyone sustain a negative cash flow for very long; no matter how much you start with if you spend more than you make eventually you go broke.

Recessions cannot end until the conditions that caused the recession are removed from the economy.  This is elementary logic and obvious to anyone with an IQ larger than their shoe size.

For an inventory recession growth returns when enough capacity is destroyed through layoffs and inventory selloffs to bring capacity and demand back into balance.  Employers then hire new workers and the economy recovers.

For a credit recession, however, there is a much larger problem: The reason real interest rates went negative is that debt has a carrying cost and consumes free cash flow; so long as the debt taken on in the credit binge remains the cash flow impact also remains.

Default and bankruptcy clears excessive credit (debt) from the system – if it is allowed to occur.  But if it is not, then the bad debt remains on the balance sheets somewhere and the cash flow impact remains in the economy.  Employment remains weak, capital spending restart attempts falter as demand fails to return and credit quality continues to remain insufficient to support new credit demand.

The consumer is 70% of our economy, give or take a few points.  The consumer’s “savings rate” (which government blithely declares as income minus spending), which was in fact negative (that is, consumers were spending more than they made through taking on more and more debt), but is now solidly positive at 6.9%.

The impact of this (6.9% X 70%) is an immediate 4.83 decrease in real GDP. This is the math, and the math is never, ever wrong.

The truly bad news however is that most of the time saving in fact turns into capital formation – that is, it becomes investment.  But government doesn’t differentiate between actual savings and debt repayment – their formula is simply “income less spending = savings rate.”

Consumers are not saving, they are paying down debt in a furious attempt to avoid defaulting on nearly $1 trillion in outstanding credit card balances that have gone from 11% interest to 29.6% along with OptionARMs that are experiencing a tripling of payments while the home’s value is underwater and precludes refinance, all while consumers are being laid off by the hundreds of thousands monthly.”

I hope this makes the current situation clear (er). I remain very cautious in the current environment, and whilst I think that a slight recovery is possible by the end of this year, it is likely to be short lived, as the infamous “double dip” recession could take hold (that or an L shaped recovery, which could last for years). A great investor once told me: “Let the price come to you, don’t rush it”. I think the same thing can be said for economic indicators, and the market. We should always wait for the data to clearly tell us what is happening, instead of anticipating something thay may or may not materialize.

I will end this with my usual quotation, this one from Ludwig Von Mises on Credit based recessions:

‘The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression (recession), is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.’ -Ludwig von Mises

P.S: The “Golden Cross” that Kneale mentioned is likely to be invalid, as the 200 Day Moving Average is declining. Merryl Lynch has posted research on this, and doesn’t seem to find upside in the market anywhere near 20% following a cross (link). I’m surprised that a journalist for CNBC is not aware of these implications. I question where he gets the “20% increase” number, as other studies I’ve read haven’t found this to be true. In fact, in his research regarding the Golden Cross with a decling 200 day MA, Goepfert concludes:

“…the returns going forward, up to six months later, were little bettern than random and not statistically significant. In fact, in the shorter-term they were a little worse than random. Only when we look out a year do we see some out-performance.”

I would also suggest reading research by Robin Griffiths (well respected technical analyst, and former senior technical analyst at HSBC) and Deborah Owen (Fellow of the Society of Technical Analysts) concerning the cross, as he clearly states that both averages should be rising:

“A cross of the shorter moving average over the longer one can be used to generate buy and sell signals. If both averages are rising when the shorter term average breaks above the longer one, it is known as a “golden cross” and suggests that bullish sentiment is growing stronger.”