Sunday, May 20, 2018

Koesterich, Portfolio Construction for Today’s Markets

Russ Koesterich, who is currently responsible for asset allocation and risk management for BlackRock’s largest investment team (managing about $80 billion), has written a book for financial advisors. Portfolio Construction for Today’s Markets: A Practitioner’s Guide to the Essentials of Asset Allocation (Harriman House, 2018) explains, in general terms, how to combine assets in a risk-controlled manner.

Portfolio construction is especially daunting in a low interest rate environment. Low rates have not only reduced income from bonds in a portfolio. Many bond funds, searching for yield, have gone out in duration, increasing their riskiness. “They will experience larger than typical losses when rates rise.” In brief, bonds are not playing their traditional role: they are providing less income, and they are becoming a less reliable way to manage volatility.

In separate chapters Koesterich discusses portfolio constraints (the most important of which is risk), diversification, factors, and how to make a stab at forecasting returns using, among other inputs, historical returns and expected risk (as “the second sanity check”). Only then is it time to build the portfolio, described in a chapter titled “Some Assembly Required.”

Koesterich considers several approaches to constructing a workable portfolio, in increasing degrees of viability: minimum risk, maximum return, maximum Sharpe ratio, targeted return while minimizing risk, and maximum return within a particular risk budget. The last two approaches result in strategic portfolios. “Think of the strategic portfolio as the portfolio best suited to the investor’s needs over the long term. It provides a baseline allocation consistent with investment goals. This is the portfolio the investor is trying to beat when they decide to get fancy and time the market [tactical asset allocation]. If the investor finds that they can’t really time the various asset classes to produce better results, these strategic portfolios are the default to revert to.” If, however, the investor wants to make tactical adjustments, thereby tilting his portfolio away from its long-term, strategic allocation, he might consider changing his risk budget, “raising it when expecting particularly high returns and lowering it when concerned about a bear market.”

Five rules can guide the process of building a portfolio: (1) start with a goal, (2) be both explicit and parsimonious when it comes to constraints, (3) be honest about risk, (4) diversify, and (5) remember the denominator: always think in terms of risk-adjusted returns.

Wednesday, May 16, 2018

Kobrak and Martin, From Wall Street to Bay Street

If your first reaction upon seeing the title of this post was “from Wall Street to where?” you personify one reason that Christopher Kobrak and Joe Martin felt it necessary to write From Wall Street to Bay Street: The Origins and Evolution of American and Canadian Finance (University of Toronto Press, 2018). The book traces the intertwined yet uniquely defined paths of financial development in the U.S. and Canada from colonial times to the 2008 financial collapse.

It’s of course impossible in a few paragraphs to do justice to the authors’ thorough history, so I decided to confine myself to a single event and to the authors’ conclusion about the relative success of the Canadian financial system.

The event, which resonates today, was the passage of the infamous Smoot Hawley Tariff, signed into law by Herbert Hoover in 1930. According to many economists, it was one of the reasons a stock market correction turned into a worldwide depression. The tariff “increased the rate on dutiable-good imports from 39 to 53 per cent, the highest in history. Canada’s exports to the United States plummeted by 70 per cent. … The full force of the Great Depression fell upon Canada’s staple exports—hardest hit were the markets for cattle, dried codfish, copper, and wheat…. Average incomes declined by 48 per cent, but in the Prairie province of Saskatchewan they declined by 72 per cent.”

Smoot Hawley, which exacerbated an already weak grain market for Canada, was introduced in the midst of a Canadian election campaign. The U.S. tariff became a major campaign issue, especially among farmers, and “the result was a resounding defeat of the Liberal government of William Lyon Mackenzie King and the election of a Conservative government led by R. B. Bennett, a former bank director and the richest man to ever hold the office of prime minister of Canada.” In the wake of the Depression, the three largest provinces elected populist governments.

Over the years the Canadian financial system has exhibited more self-restraint than has the American. “It has avoided the corporate governance scandals that nearly destroyed investor faith in American equities in the nineteenth century, in the 1920s, and most recently during the first few years of the twenty-first. Its legal system has avoided the excesses of the American tort system, making insurance cheaper and easier to acquire. Its corporate governance system remained more elitist and is still more activist than the American, whose New Deal legislation in the 1930s increased the obstacles and decreased the incentives for active shareholder governance, a shift that has only recently begun to be reversed. Perhaps most importantly, Canada’s more concentrated, domestic banks have given it a large measure of financial independence from America and the rest of the world.”

The American and Canadian financial systems reflect their national cultures and national priorities. But perhaps a sober reflection on how each country got to where it is today could prompt some tweaks to the systems to make them both more vibrant and more stable. From Wall Street to Bay Street is a good place to gain material for such reflection.

Sunday, May 13, 2018

Doig, High-Speed Empire

A couple of weeks ago 27 EU ambassadors to Beijing (with the exception of the ambassador from Hungary) signed an internal report criticizing China’s belt and road program, saying it creates an unfair global trade environment. China is trying to expand its freight railway services in Europe, normally providing countries with both the contractor and the money, in the form of a long-term loan, to build the tracks. And then there’s the Maritime Silk Road, which represents 10% of China’s GDP. In 2016 maritime shipping carried 94% of trade between China and Europe by weight and 64% by value. A more profitable part of the Maritime Silk Road, and potentially even more worrisome for Europe, is port management. China now controls about one-tenth of all European port capacity.

I have been following some of these infrastructure developments in Europe, so I was delighted to come across Will Doig’s High-Speed Empire: Chinese Expansion and the Future of Southeast Asia (Columbia Global Reports, 2018). It’s a short book, about 100 pages, that reads more like a series of long magazine articles. And I mean this as a compliment. It gives color to what could otherwise have been a dry politico-economic analysis.

I have never understood China’s “One Belt One Road” name for its massive infrastructure initiative and am forever slipping up. Why the “belt” refers to the overland infrastructure network and the “road” describes its web of shipping lanes is beyond me. But, however it got its name, it has, in the five years since it was officially launched, come to encompass more than 60 countries in Asia, Africa, and Europe and over a trillion dollars in spending.

Doig writes about a single project, “more an idea than a cohesive plan”: China’s desire to create a Pan-Asia Railway running from Kunming, the capital of Yunnan, through Laos, Thailand, and Malaysia, and terminating in Singapore.

He begins his account in the tiny city of Boten, Laos, just over the Chinese border. It was meant to be China’s gateway into Southeast Asia, with plans including a trading center, manufacturing complex, and storage facilities. But instead, for some years, it was simply a “gaudy little kingdom of clubs, drugs, casinos, hookers, and crime both petty and organized” that serviced, and was serviced by, mostly Chinese nationals. In time it became not only unsavory but dangerous, with gunshot-riddled corpses turning up in alleys. Eventually, in 2011, China shut it down, cutting the city’s power and cell phone signal.

China was, however, undeterred in its dream to build a railroad through Laos. Despite many political setbacks, work has finally begun on the $6+ billion project. The initial investment will be just over $2 billion, “of which China will contribute about $1.6 billion. Laos will cover the rest.” But since Laos doesn’t have that kind of money, it will borrow most of its share from China.

And what is happening in Boten today? It is “reincarnating, bit by bit, as a commercial hub…. You can see offshoots of the city’s new relevance in the wilderness just beyond its borders, where flashes of alien modernity have materialized: PetroLao gas stations, stucco guesthouses, and the weirdest: a palatial furniture showroom fully stocked with flashy bedroom sets.” Nearly everyone working in Boten is on the payroll of the Boten Economic Zone Development and Construction Group, a Chinese company. The company runs all of the city’s services.

In his book Doig traverses the railroad’s proposed route, writing about China’s relations with Thailand and Malaysia as well as Laos. And he issues some warnings, based on China’s earlier infrastructure deals. For instance, China lent the Sri Lankan government money for a seaport and built a new airport nearby. “The deal and others like it left Sri Lanka owing China $8 billion it couldn’t repay.” Sri Lanka ended up giving Beijing control of “one of the most strategically placed deep-sea ports in the world.” The airport, it seems, was not such a great deal. It is “so underutilized that guards were reportedly hired to prevent local wildlife from turning the empty concourse into an indoor habitat.”

China is using its financial muscle to reap economic and geostrategic benefits from its “partnerships” with other countries. High-Speed Empire illustrates some of the challenges it faces and how it ultimately manages to overcome them.

Wednesday, May 9, 2018

Carey et al., Go Long

Go Long: Why Long-term Thinking Is Your Best Short-term Strategy (Wharton Digital Press, 2018) by Dennis Carey, Brian Dumaine, Michael Useem, and Rodney Zemmel is a short book packed with managerial, and investing, insight. In the first part it profiles leaders who went long: Alan Mulally at Ford, Larry Merlo at CVS, Paul Polman at Unilever, Ivan Seidenberg at Verizon, Sir George Buckley at 3M, and Hewlett Packard Enterprise and Costco director Maggie Wilderotter. Part two offers principles for leaders who want to start thinking long term.

Some CEOs use long-term metrics as organizing principles. Alan Mulally invoked PGA (profitable growth for all), which is revenue times margins. His goal at Ford, even as he faced a $17 billion shortfall in a single year when he joined the company, was to use that measure to achieve a 10% to 15% compounded annual growth rate. How would Ford achieve this kind of growth? “The only way to raise revenue is to make products and provide services people want and value, and good companies improve their margins every year by improving quality and productivity. Mulally says the trick is to work both of those levers.” At each of his business review meetings, Mulally asked his 16 top executives to apply PGA to a five-year horizon: “imagine five bars representing profits going out five years, and each one going up 15%. That simple exercise got the executives to look five years out every week, every quarter, every year—even while they were dealing with short-term crises.”

The title of the chapter dealing with Sir George Buckley is “R&D Is the Last Place to Cut.” In the four years before Buckley became chairman and CEO of 3M in 2005,capital spending had been slashed by 65% and R&D by 25%. Buckley believed that the company’s sluggish growth was the result of shortchanging innovation. He “reached back into 3M’s history and reinstated a key metric known as the New Product Vitality Index.” He calculated that to grow at a 4% compounded annual growth rate above market growth would require that more than 30% of the company’s revenues come from products introduced in the last five years. “By the time he took mandatory retirement at age 65 in 2012, Buckley had grown the share of new products launched over the previous five years from 8% of sales to 34% of sales.”

Traditionally Wall Street hasn’t rewarded companies that plow earnings back into R&D and other capital expenditures. Goldman Sachs found that between 1991 and 2016 the stock returns of companies offering the highest combined dividend and share-buyback yields outpaced those of companies that spent more on R&D. Is the trend starting to shift? It’s too early to say, but last year “those companies in the Goldman study that spent more on capital expenditures and R&D outperformed those offering high dividends and buybacks by 11 percentage points.”

Go Long is a wonderful mini-manual for corporate executives and members of boards of public companies. But it is also meant to educate investors, to get them to think beyond the next quarter and to reward companies that focus on longer-term goals.

Sunday, May 6, 2018

Tuff & Goldbach, Detonate

In Detonate (Wiley, 2018) Geoff Tuff and Steven Goldbach, both principals at Deloitte, explore “why—and how—corporations must blow up best practices (and bring a beginner’s mind) to survive.” The general thesis may not be original, but the book brings together so many insights that it’s a decidedly worthwhile read.

Here I’ll summarize three points the authors make.

First, force your opponents to make a choice. “[A] truism in poker is that you can’t learn anything about your opponents if you don’t bet. … If you want to get information about your opponent, you need to force them to make a decision.” Businesses, they contend, should “stop asking, and start observing, simulating, and inferring.” A very funny cartoon illustrates their point.

Second, don’t try to design a whole system at the outset. The “mother of all snow forts” is a case in point. A snowstorm that leveled Boston in 2006 prompted one of the authors and his sons to design an elaborate snow fort, with an access point where they could drop into the fort from a second-floor bedroom window and “an offshoot tunnel that went right up to the kitchen window from which they could supply the fort with hot chocolate and something slightly stronger for the adults…. After a morning’s worth of design and a table full of drawings, they truly had something magnificent. Then they did nothing.” The task was too daunting. The authors ask what would have happened had they just started digging instead of spending all their time planning. They might have created something magnificent, or perhaps not much more than an igloo. But it would at least have been something rather than nothing. The point of the story: “focus on a minimally viable move to get going, trusting that something good will come of it even though you may not have the end game in mind.” Another cartoon illustrates the futility of over-systematizing in the planning stage.

Third, focus on the core rather than the periphery. Although there is a rationale for tinkering around the edges, the authors want to shift “the core from the inside.” They “don’t think you can blow up playbooks effectively and permanently from the periphery.”

Detonate challenges assumptions, tradition, and apathy. It is a business book, yes, but some of its principles reach far beyond the corporate world. I thoroughly enjoyed it.

Thursday, May 3, 2018

Arthur, Cyber Wars

Charles Arthur’s Cyber Wars: Hacks That Shocked the Business World (Kogan Page, 2018) takes the reader through some well-known and not so well-known hacks: Sony Pictures, HBGary, John Podesta’s inbox, TJX, ransomware, TalkTalk, and Mirai. Each chapter concludes with some lessons and suggestions, but the reality is that we will never make every system secure. We can simply make it a tad harder for the hackers to penetrate “our space” and either gain access to our data or lock us out from it.

The tales of woe told here explore the range of tools hackers have used. For those of us with zero hacking skills it’s an enlightening, if depressing, read.

Sunday, April 29, 2018

Cunningham & Cuba, The Warren Buffett Shareholder

I have often marveled at the number of books written about all things Buffett and Berkshire. Reading The Warren Buffett Shareholder: Stories from inside the Berkshire Hathaway Annual Meeting (Harriman House, 2018), I learned one reason for this profusion: they sell. In 2005 The Bookworm, an Omaha bookstore that is the only non-Berkshire affiliated booth at the annual meetings, sold 3,500 copies, or 8.5 tons!, of Poor Charlie’s Almanack. The bookstore at Omaha’s Eppley Airfield, which offers books that Buffett and Munger recommend at each annual meeting, on at least one occasion needed the police to control the crowd. And book signings regularly take place during these meetings in an Omaha Dairy Queen. This is, I guess, what happens when Warren Buffett says, in response to a question about what a young person should do to become a great investor, “Read everything you can.” And when he claims to have read every book in the Omaha Public Library with the word finance in the title by the age of ten, some twice.

The latest addition to the Buffett/Berkshire corpus is a collection of 40 reminiscences about Berkshire annual meetings. One theme running throughout is the people who attend, the relationships that are formed and cemented, the “faith” that is deepened. Yes, attendees hear Warren Buffett and Charlie Munger answer questions, but many of the shareholders are familiar with what they’re likely to say. After all, Berkshire has made only small tweaks to its investing principles over the years. Moreover, they could sit at home and watch streaming video of the meeting. The draw is not so much the words as the ethos and the people. Attendees describe the experience in religious terms as a pilgrimage or a revival meeting, in mundane terms as an oil change (admittedly, for the soul).

Berkshire has a relationship with its shareholders that no other company does. And thus its shareholder meetings are unique. The Warren Buffett Shareholder demonstrates just why that is and why people keep going back, year after year. It’s hard not to feel better having read it.