Wednesday, June 20, 2018

Gannett, The Creative Curve

The thesis of Allen Gannett’s The Creative Curve (Currency / Crown, 2018) isn’t revolutionary. But I guess that’s the point. If it were, the book wouldn’t sell well. It would defy the science of what becomes a hit.

More interesting, however, at least to me, than how to identify the next big thing, whether it’s a new Ben & Jerry’s ice cream flavor or a blockbuster movie, is how people prepare to be creative. Because aha moments don’t happen in a vacuum. In the shower, perhaps; in a vacuum, never.

Gannett postulates four laws of the creative curve: consumption, imitation, creative communities, and iterations. Here I’ll look only at the first law.

How can some people be such successful serial entrepreneurs? In part, it’s due to pattern recognition, the ability to develop an uncanny instinct for opportunity. “Research shows that when entrepreneurs have significant prior knowledge, they no longer need to engage in slow, deliberate searches for new ideas. On the contrary, their prior experience gives them a rich library of exemplars they can access automatically.”

To build this mental library, would-be creators voraciously consume highly relevant material. In fact, in the case of already successful creative artists, it seems to be part and parcel of their daily routine. They spend about 20 percent of their waking hours expanding their knowledge of their field. Writers read, artists go to art shows, songwriters listen to music, old and new.

The 20 percent principle, the author contends, provides the building blocks necessary for aha moments to flourish. “This accumulation of prior knowledge fills up the brain with examples and concepts that artists then use to uncover non-obvious insights. … You can’t have insights about things you don’t know anything about.”

In brief, if you want to be a creative whatever, and that includes being a creative investor or trader, you need to accumulate a large repertoire of relevant material—and keep adding to it. Aha moments come only to the well prepared.

Sunday, June 17, 2018

Carreyrou, Bad Blood

On Friday Elizabeth Holmes, the founder of Theranos, and its former president Ramesh “Sunny” Balwani were criminally charged with wire fraud. These charges came three months after the SEC sued Holmes and Theranos for a “massive fraud” at the company.

John Carreyrou, a lauded investigative reporter at the Wall Street Journal who covered Theranos extensively from 2015 on, has written a spine-chilling book, Bad Blood: Secrets and Lies in a Silicon Valley Startup (Alfred A. Knopf, 2018).

It’s hard to imagine, amid all the suspicions, firings, and general upheaval, that Theranos got away with its alleged fraud for as long as it did. It was the persona of Elizabeth Holmes (along later on with some heavy legal fire power) that kept it going, that attracted big dollars from normally savvy investors and big names to the company board, that convinced companies such as Safeway and Walgreens to offer Theranos’s flawed finger-stick blood tests (although they later pulled back). People were bewitched by her “mixture of charm, intelligence, and charisma.” They didn’t see her much less flattering side.

Put Bad Blood at the top of your summer reading list. You won’t regret it

Wednesday, June 13, 2018

Yu, Leap

Legally or illegally, companies have for centuries copied the intellectual property of their competitors and encroached on their market share. One has only to think back to the commercial espionage of Francis Cabot Lowell, who in 1810-11, while strolling through dozens of British cotton mills, memorized critical details of mechanized textile manufacturing. Using this information, his Boston Manufacturing Company and eventually mills throughout New England took the growing American mass market away from British textile exporters.

Leap: How to Thrive in a World Where Everything Can Be Copied (PublicAffairs/Hachette, 2018) by Howard Yu is, in the best sense of the word, a story book. It tells tales of woe as well as tales of resilience. These case studies all have a point, but, even if they didn’t, they would be fascinating in and of themselves.

Wu, a professor at the International Institute for Management Development (IMD) in Lausanne, Switzerland, believes that the key to outlasting copycat competition is to leap. “Pioneers must move across knowledge disciplines, to leverage or create new knowledge on how a product is made or a service is delivered. Absent such efforts, latecomers will always catch up.”

Wu articulates five principles necessary for making a successful leap: (1) understand your firm’s foundational knowledge and its trajectory, (2) acquire and cultivate new knowledge disciplines, (3) leverage seismic shifts, (4) experiment to gain evidence, and (5) dive deep into execution. These principles, as stated, are somewhat telegraphic, but Wu develops them through compelling case studies from companies spanning the globe: for instance, Steinway (an example of what not to do in the face of competition, in its case, from Yamaha), Procter & Gamble, Novartis, WeChat, Recruit Holdings, and John Deere.

Leap is the kind of book that everyone with an interest in business can profit from. And here’s a lesson that everybody, active investors/traders in particular, can profit from. “Successful executives often exhibit a bias for action. But it’s even more important to separate the noise from the signal that actually pinpoints the glacial movement around us. Listening carefully to the right signals requires patience and discipline. Seizing a window of opportunity, which means not necessarily being the first mover but the first to get it right, takes courage and determination. To leap successfully is to master these two seemingly contradictory abilities. The discipline to wait and the determination to drive, in balanced combination, often pay off handsomely.”

Monday, June 11, 2018

Batnick, Big Mistakes

Consistently beating the market is insanely difficult. Whether it’s because the market is for the most part efficient, whether it’s due to the paradox of skill, whether it’s the result of the behavioral bogeymen that prompt us to do the wrong things at the wrong time, whatever the reason, no investor, not even the most successful, remains unscathed. Michael Batnick, director of research at Ritholtz Wealth Management, who admits to having made thousands of unforced trading errors himself, delves into this phenomenon in Big Mistakes: The Best Investors and Their Worst Investments (Bloomberg/Wiley, 2018).

In 16 chapters he writes about the mistakes of Benjamin Graham, Jesse Livermore, Mark Twain, John Meriwether, Jack Bogle, Michael Steinhardt, Jerry Tsai, Warren Buffett, Bill Ackman, Stanley Druckenmiller, Sequoia, John Maynard Keynes, John Paulson, Charlie Munger, Chris Sacca, and himself. Even though most of these mistakes are well known to students of investing history, Batnick frames them in a new, for the most part behavioral, way.

He distinguishes between “a lousy investment” and an unforced error. “Your thesis was wrong, or what you thought was already in the price; things like this are all part of the game. But oftentimes, we’ll act impulsively, even when we ‘know’ what we’re doing is a mistake. Few people are spared from unforced errors, and the way they usually manifest themselves is because we can’t handle people making money while we aren’t.” Stanley Druckenmiller, for instance, “played the game at a level few ever have.” He was 130% net long going into Black Monday and still made money in October 1987. And yet even he made an unforced error when he “couldn’t bear to see Quantum grinding its gears as a bunch of small-potato upstarts were racking up huge returns” in the late 1990s and bought $6 billion worth of tech stocks. … [I]n six weeks I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself.”

Elaborating on a quotation from Livermore and further fleshing out the distinction between a bad investment and an unforced error, Batnick acknowledges the limitations of learning from investing mistakes. “Investing is inherently an act of uncertainty, so we can never say to ourselves, ‘I’ll never let that happen again!’ Sure, there are very specific mistakes that you won’t repeat, like buying a triple-levered inverse ETF and holding it for three months. That’s something you do one time and never repeat. But like Livermore said, the mistake family is too large to avoid all of them. And no amount of market quotes will change the fact that losing money is a part of investing. Risk management is a part of investing. Repeating mistakes is part of investing. It’s all part of investing.” Even so, we can, and should, focus on avoiding unforced errors—errors such as straying outside our field of competence, confusing skill with luck or genius with a rising market, over-concentrating a portfolio (think Sequoia with Valeant or Charlie Munger with Blue Chip Stamps), buying at market tops and selling at market bottoms.

Big Mistakes is a humbling book. Sentences such as “Imagine that you were physically exchanging stock certificates with Jim Simons of Renaissance Technologies every time you went to buy or sell a stock” might be enough to send investors scurrying to buy an index fund. But the lure of joining the pantheon of great investors/traders remains powerful. Batnick may not provide the path to such success, but he demonstrates that perfection is not required. “Mistakes,” as Peter Bernstein once said, “are an inevitable part of the process.”

Wednesday, June 6, 2018

Pearson, How Hard Can It Be?

I read a lot of fiction, mostly mysteries/thrillers, for relaxation and/or escapism, the vast majority of which I never write about. After all, who cares about my reactions to the latest exploits of Armand Gamache or Jack Reacher or all those girls or women “on/with/in,” pick your preposition?

Perhaps no one cares about my reactions to Kate Reddy either, but since I requested a copy of Allison Pearson’s How Hard Can It Be? (St. Martin’s Press, 2018) from NetGalley, I feel a duty to write a few words about it. Moreover, the reason I requested it was that, in the novel, Kate returns to the hedge fund she started years earlier, even though, as it turned out, this was the least realistic thread of the storyline.

How Hard Can It Be? is a sequel to Pearson’s blockbuster (four million copies sold worldwide) debut novel, I Don’t Know How She Does It, described by Oprah Winfrey as “the national anthem for working mothers.” I didn’t read the original novel, but its sequel is both incisive and hilarious. It speaks, of course, more to women than to men.

Kate Reddy, now pushing 50 and impatient to relinquish her all-engulfing role as wife and mother, sets out to re-enter the workforce. Of course, the kids, now teenagers, don’t go away, nor does her increasingly distant husband. And the financial world isn’t exactly scrambling to hire a 50-year-old whose only “relevant” work experience in seven years was serving as treasurer of the village parochial church council and chairman of the governors at a community college.

How hard can it be? Very hard. But Kate didn’t compile an impressive track record in the City and survive years of motherhood to be daunted by little things like forgetfulness, a spreading middle, and the truth (does she really have to be nearly 50?).

This novel is a paean to grit, resourcefulness, humor, and new-found love. Women can rightfully be proud of Kate.

Sunday, June 3, 2018

Ball, The Fed and Lehman Brothers

Laurence M. Ball, a professor of economics at Johns Hopkins University, is convinced that (1) the Federal Reserve Bank had the authority to rescue Lehman in 2008 and that (2) in any event, the beliefs of Fed officials about their legal authority were not the real reason they chose not to rescue the firm. In The Fed and Lehman Brothers: Setting the Record Straight on a Financial Disaster (Cambridge University Press, 2018), based on publicly available sources, Ball makes his case.

After a deal to sell Lehman to Barclays fell apart on September 14, what could the Fed have done to avert Lehman’s bankruptcy the next day? Actually, as Ball points out, not all of the Lehman enterprise failed on the 15th. LBHI, the holding company, filed for bankruptcy, along with most of its subsidiaries. But one subsidiary did not: Lehman Brothers Inc., the company’s broker-dealer in New York. “The Fed kept LBI in business from September 15 to September 18 by lending it tens of billions of dollars. After that, Barclays purchased part of LBI and the rest was wound down by a court-appointed trustee.”

The usual explanation for the Fed’s refusal to lend to LBHI was that, under Section 13(3) of the Federal Reserve Act, the loan had to be “secured to the satisfaction of the Reserve Bank.” Fed officials took this to mean that the Fed cannot make a loan if there is a significant risk that it will lose money on the deal. This provision did not require that Lehman be solvent, but “examining Lehman’s solvency helps us to understand what assistance the firm needed to survive its liquidity crisis, and to assess its longer-term prospects.” Ball contends that, with mark-to-market valuation in the distressed markets of September 2008, Lehman was near the edge of solvency, so “it was probably solvent based on its assets’ fundamental values.” The problem, of course, was not solvency but liquidity. Lehman, Ball calculates, “would have needed about $84 billion of assistance to stay in operation for a period of weeks or months” while it looked for long-term solutions to its problems.

Ball argues that the real villain in Lehman’s bankruptcy was Hank Paulson, that he insisted on the bankruptcy and that Fed officials acquiesced. Moreover, he suggests, neither Paulson nor Fed officials fully appreciated the severe damage to the financial system that Lehman’s bankruptcy would cause.

Ball supports his hypothesis with ample documentation. Whether readers come away convinced that the Fed made a grievous error in not being the lender of last resort to Lehman will probably depend on their view of the Fed. And even if future Fed leaders “take the Lehman lesson to heart,” they may be hamstrung in their actions. The Dodd-Frank Act revised Section 13(3) to limit the Fed’s lending authority and to make all lending subject to the approval of the Secretary of the Treasury, a political appointee.

Wednesday, May 30, 2018

Edwards, American Default

No, this is not a dystopian account of the consequences of bad tax policy, wanton spending, and political gridlock. American Default (Princeton University Press, 2018), by Sebastian Edwards, is, in the words of the subtitle, The Untold Story of FDR, the Supreme Court, and the Battle over Gold. And a fascinating story it is. I couldn’t put this book down.

At its heart is “the great debt default of 1933-1935, … when the White House, Congress, and the Supreme Court agreed to wipe out more than 40 percent of public and private debts” by abandoning the gold standard, devaluing the dollar, and abrogating gold-denominated contracts retroactively.

Edwards takes the reader on the long, tortuous path to devaluation. FDR was largely ignorant of economics, not that economists of the day themselves understood the intricacies of the monetary system. He used commodity prices, especially the price of cotton, as the benchmark against which to measure the success of his economic policies. (In 1932 about half of the American population earned their living by farming.) During the first year of his administration he “obsessively” followed these prices, and “their movements often guided public policy. When commodity prices went up, the president felt confident; however, when prices faltered, the president would become very upset, and his tendency to experiment and try new policies would rise to the surface.”

The president was taken with agricultural economist George F. Warren’s “elegant charts drawn on onionskin paper.” The theory was that if the price of gold increased, higher prices for agricultural commodities would immediately follow. The New York Times reported that the administration’s goal was to adopt “a ‘commodity dollar’ which will fluctuate in line with general commodity movements instead of remaining as a constant factor through all periods of changing values.” Despite spurious theory and many stumbles, between March 1933, when Roosevelt was inaugurated, and December 1934, “the price of corn quadrupled, that of cotton almost doubled, the price of rye doubled, and that of wheat increased by 114 percent. During the same period, the Dow stock market index had increased by 67 percent.”

One of the most controversial policies, enacted at the behest of the Treasury Department, was the congressional joint resolution voiding the gold clause for both past and future contracts. If the White House’s policies rested on spurious economic theory, the legal basis for them seemed even dodgier. After all, the sanctity of contracts was part and parcel of accepted legal theory. The Supreme Court took up four cases challenging the joint resolution.

The Court, by a 5-4 vote, ruled that “the abrogation of the gold clauses for private contracts was constitutional, and debtors could discharge their debts using legal currency.” As applied to public debt, however, the Court ruled 8-1 that the abrogation of the gold clause was unconstitutional. But, again by a 5-4 vote, it “accepted the government’s secondary argument that the abrogation of the gold clause had not produced any damages to bond holders; in terms of purchasing power over goods and services, bondholders were at least as well off in 1933, as they had been at the time the Liberty Bonds were issued.” So bondholders could not sue for damages, and “there was no practical economic consequence for having passed an unconstitutional law.”

Contrary to the dire predictions of the Court minority, there was no major fallout from the rulings. The government had no difficulty rolling over its debt or issuing new securities. The U.S. abrogation was an “excusable default.”

Could an American default happen again? Yes, but, Edwards maintains, it would not be related to deflation, exchange rates, or the monetary system. The debt crisis that looms on the horizon “has a completely different genesis: it is rooted in unsustainable promises made in the present for future delivery of services.” And, presumably, this time around a default would not be excusable.

Sunday, May 27, 2018

Hall, Ideas, Influence, and Income

I’m not sure what prompted me to read Tanya Hall’s Ideas, Influence, and Income: Write a Book, Build Your Brand, and Lead Your Industry (Greenleaf, 2018). I have a hard enough time writing a few paragraphs about books for this blog. I have absolutely no desire to write a book myself.

But I thought that some of my readers, especially those who want to promote their brand or company, might be more ambitious. If you are, Hall’s book is a remarkably useful guide. Yes, this book promotes her own company, Greenleaf Book Group, a hybrid publisher and distributor that offers the benefits of both traditional and self-publishing. But in the process it explains a great deal about the new realities of publishing and marketing. Start with the sobering fact that more than 800 books are published in the U.S. every day.

If you’re contemplating writing a financial book, be forewarned that publishers are cutting back dramatically on titles in this area. (You may have noticed that the number of reviews I write has shrunk over the years. This, I assure you, is not from sloth.) So you’ll probably have to do all of the work yourself, not just write the book but see it through publication and market it. And expect to come out on the short end of the stick financially.

Hall cites a survey of book-buying behavior that says that author reputation is the most important factor in a book purchase decision. So, she recommends, build your platform early through tweets, social media platforms, newsletters, blogging, videos, presentations, webinars, and articles. Become known to a wide audience as an “expert” in the field you eventually plan to write about. Connect with your potential readers. Only then do you stand a chance of having your book end up on some kind of bestsellers list.

Let’s put it this way, Hall’s marketing suggestions only reinforced my decision never to write a book. But for those who are not deterred, Ideas, Influence, and Income is an informative read.

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.

Wednesday, April 25, 2018

Sachs, Unsafe Thinking

Following the safe path, sticking with the tried-and-true, leads to mediocrity. To thrive, especially in conditions of rapid change, you must be willing to embrace the unconventional. This is the basic thesis of Jonah Sachs’s Unsafe Thinking: How to Be Nimble and Bold When You Need It Most (Da Capo Press/Hachette, 2018).

Sachs talked with more than 100 innovators to learn how they had succeeded in taking bold, intelligent risks. The insights he gained from them, coupled with the findings of academic research, provide the backbone of his book.

The six key components of unsafe thinking (and the six parts of the book) are courage, motivation, learning, flexibility, morality, and leadership. Here I’ll share a couple of the points Sachs makes on learning and flexibility.

Being, and (worse) acting like, an expert can “lead us, unwittingly, down the path to entrenchment. … The endpoint of this path is close-mindedness and over-confidence.” It’s far better to act like an explorer, “to openly ask questions, gain knowledge in new fields, and constantly expand [one’s] expertise.” One should “spend time doing things that make you a beginner again.” Sachs explains that “engaging in just about anything that is both challenging and unfamiliar creates more cognitive flexibility. Being a rank beginner breaks down overactive pattern recognition, giving you a boost of creativity, even when you return to your area of expertise.”

Flexibility is an essential ingredient of unsafe thinking. Sachs suggests that tapping into intuition is a way of becoming flexible. Let’s say a person has a counterintuitive idea. Should he move forward with it? “Because analysis alone can’t prove the unusual idea is right, proceeding demands a heavy dose of intuition.” As Jack Welch said, good decisions come “straight from the gut.”

But intuition can be “fickle and unreliable.” It can be used as “a cover to go into biased thinking.” Intuitions aren’t truths but hypotheses that need to be tested, to be checked with feedback and data.

Unsafe Thinking is an illustrated (with stories) roadmap for navigating those situations, increasingly frequent in our fast-paced world, where more-of-the-same or incremental change just won’t do.

Tuesday, April 24, 2018

Davenport, The Space Barons

I have my feet firmly planted on the earth’s surface, with no desire to travel into space. But that doesn’t undermine the pull of Christian Davenport’s The Space Barons: Elon Musk, Jeff Bezos, and the Quest to Colonize the Cosmos (Public Affairs / Hachette, 2018). It’s a tale of intense competition, dueling styles, and cosmic dreams.

The book focuses on SpaceX and Blue Origin, although it also touches on the endeavors of Richard Branson and Paul Allen and other pioneers whose names are not so well known.

Elon Musk’s SpaceX is normally center stage in any discussion of private, entrepreneurial space exploration. Musk is, as Davenport describes him, “the brash hare” with a knack for grabbing the limelight. (Who else would, in “pure Silicon Valley swagger,” park a shiny, white rocket that stretched seven stories long outside the headquarters of the FAA?) SpaceX’s mantra is “Head down. Plow through the line.” Jeff Bezos, by contrast, has been “the secretive and slow tortoise.” In fact, the turtle is Blue Origin’s mascot, the embodiment of one of Bezos’s favorite Navy SEAL sayings: “Slow is smooth and smooth is fast.” And the company’s only partially turtle-like motto is “Gradatim Ferociter” (step by step, ferociously).

In prose more than worthy of a staff writer at the Washington Post, Davenport glides effortlessly between biographical vignettes, engineering and financial challenges in building spacecraft, government obstacles to private space exploration, project failures and triumphs, and rivalry as “the best rocket fuel.”

Musk and Bezos have different goals, goals that neither of them is likely to see achieved in his lifetime. Musk wants to colonize Mars, a “fixer-upper of a planet.” Mars could be a plan B habitat in case something horrific happens to Earth, such as an asteroid strike that threatens to wipe out humanity. Bezos wants to preserve Earth by zoning it “residential and light industrial” and moving all heavy industry into space. “The thing that’s going to move the needle for humanity the most,” he said, “is mining near-Earth objects and building manufacturing infrastructure in place.” Both goals seem—well—just plain weird. But then so was transforming a tiny online bookstore into a retail juggernaut and cloud computing service company. The sky is no longer the limit.

Sunday, April 22, 2018

Wapner, When the Wolves Bite

The title of Scott Wapner’s book, When the Wolves Bite: Two Billionaires, One Company, and Wall Street’s Most Epic Battle (Public Affairs/Hachette Book Group, 2018), comes from an article in the Yale Law Journal: “Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System.” That’s as academic as the book gets, which is fine, because, even if you know most of the story, it’s still a page-turning account of what became a vituperative personal battle over Herbalife. Is Herbalife in effect a Ponzi scheme that the government should shut down (Bill Ackman’s position) or is it a legitimate company on which investors can make money, especially in the event of a short squeeze (Carl Icahn’s view)?

Scott Wapner was the obvious person to write this book since he hosted “the brawl” between Ackman and Icahn on CNBC’s Halftime Report (January 25, 2013) in which Icahn, despite his Princeton philosophy degree, sounded eerily like his friend Donald Trump, with claims such as “as far as I’m concerned the guy [Ackman] is a major loser.” Unfortunately for Ackman, Icahn would be right in one sense—Ackman would take a major loss on his short Herbalife position and Icahn would profit handsomely from his investment in the company.

Herbalife is a multilevel marketing (MLM) company in which distributors are compensated for what they sell as well as for how many new recruits they bring in. In its swashbuckling early days it often seemed to cross the line of legality, and, even as the shorts and longs battled it out, the FTC fined Herbalife $200 million and put in place regulations to ensure that it had real customers and didn’t misrepresent how much money its distributors could make.

Wapner delves into the early research that eventually prompted Ackman to short the company’s stock and explores the role of activist investors. But at its heart When the Wolves Bite is a tale of outsize egos going to battle using the money of investors in their funds. Ackman came out bloodied, his reputation tarnished (not only by his Herbalife position but also by his forays into Valeant and ADP), and his assets under management now half their 2015 peak. Carl Icahn, in the meantime, stepped down as President Trump’s special adviser on deregulation amid controversy and is smarting from three straight years of either outright losses or massive underperformance in his investment fund.

Is there a moral to the story? I could suggest several, but I’m sure my readers could think of even more. So I’ll leave it to your imagination. In the meantime, if you want an engaging, fast read, When the Wolves Bite may be just the ticket.

Wednesday, April 18, 2018

Schilit, Financial Shenanigans, 4th ed.

It has been 25 years since Howard M. Schilit first published Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports. And it has been eight years since I reviewed the third edition of the book, starting, and hopelessly dating, my post with the words: “with Jeff Skilling (and now Richard Scrushy) back in the news….” It seems like a lifetime ago. But, alas, financial shenanigans never go out of style. And investors must keep an eye out for them.

In this fourth, fully revised and updated edition (McGraw-Hill, 2018), Howard Schilit, with the help of co-authors Jeremy Perler and Yoni Engelhart, delves deep into ways in which companies, even reputable companies, cook their books and corporate management teams fool investors. The book is a must read for every active investor. And, of course, a bonanza for short sellers.

So, what kinds of ruses do companies use? They manipulate earnings, cash flows, and key metrics, and they employ “creative” acquisition accounting. Schilit explains these ploys in easily understandable prose and illustrates them with case studies.

Let’s look at a single case study, new to this edition, and one of my personal favorites: Valeant. In 2007 Valeant hired McKinsey & Company to help jump-start its growth. The team, led by Michael Pearson, “advised a radical strategy—cutting internal R&D and pursuing growth through acquisitions and price increases.” The following year Valeant recruited Pearson to become its CEO, and he set out on an acquisition spree.

In 2010 Valeant and Canadian-based Biovail agreed to merge and, for tax purposes, to locate the headquarters of the combined company in Quebec. Biovail had had a sordid accounting history, but Valeant overlooked such “trivial details.” Two years later Valeant acquired another company with a well-known history of accounting problems, Medicis. In 2013 Valeant paid a steep premium for the financially troubled Bausch & Lomb. Then, in the widely reported and followed “unorthodox” partnership with Bill Ackman, the company set its sights on Allergan but was rebuffed. In 2015 Valeant acquired Salix Pharmaceuticals, another troubled company “just working its way through a major accounting scandal.”

With each acquisition investors cheered and Valeant’s stock price jumped. When Pearson became CEO its stock price was $13.24. Soon after the Salix acquisition it hit its all-time high of $262.52. Expensive acquisitions of tainted or troubled companies caused Valeant’s GAAP-based losses to intensify, “but the profitability metric that management focused on, ‘cash earnings,’ grew and compounded.” This was accounting gimmickry. “Acute investors understood that while it was impossible to know the exact catalyst that would spark the unraveling, they knew the downfall would be inevitable, no matter how big the balloon inflated.”

A Hillary Clinton tweet about price gouging dinged the stock, but it was the expos√© of Valeant’s fraudulent relationship with Philidor Rx, a mail-order pharmacy, that sent its stock into free fall. Pearson was ousted as CEO, the SEC began investing the company for fraud, and all the debt raised to finance acquisitions came back to haunt it. “By April 2017, … Valeant’s share price crash-landed below $9, an incredible decline of 96 percent from its summer 2015 peak.”

Analysis in hindsight, of course, is much easier than analysis in real time, but with the proper tools investors can avoid companies poised to crash and burn—or short them. Financial Shenanigans is a great place to start learning the ropes.

Sunday, April 15, 2018

Brodie and Harnack, The Trust Mandate

The Trust Mandate: The behavioural science behind how asset managers really win and keep clients by Herman Brodie and Klaus Harnack (Harriman House, 2018) is a short book (about 130 pages of text). It starts by looking at some seeming anomalies regarding which managers attract the most asset inflows—notably, not necessarily the best performers. A lot of “soft factors” go into the decision to hire (and fire) an asset manager. People search for “personal character traits to help them make predictions about the manager’s future behaviour or, at least, to reassure them that the positive impressions they have gained elsewhere are justified.” They want an asset manager who is trustworthy, who is both willing and able to act in their interests.

Trust, the authors explain, is “inseparable from risk or vulnerability. There is no need for trust in the absence of risk. … So, in a risk-oriented business, like asset management, trust is a genuine asset—a form of social capital.”

The authors cite a curious finding regarding the relationship between trust and market efficiency. In an efficient market, as we know, prices should respond fully and swiftly to the arrival of firm-specific news. And yet, prior to Sarbanes-Oxley, “this rapid adjustment tended to occur only if the firm was incorporated in a high-trust region. If the firm happened to be based in a lower-trust region, investors were less likely to take the information at face-value. Their hesitation caused the initial stock price reaction to be more sluggish.” Think, for instance, of post-earnings-announcement drift. The region of the U.S. with the highest level of trust was the Northwest; with the lowest, East South Central (Kentucky, Tennessee, Mississippi, Alabama). Following the introduction of the Sarbanes-Oxley Act, “the effect was eliminated. Regulation, it appears, has the possibility to raise the minimum level of trust in all firms—even in a sophisticated and well-developed capital market like in the US.”

How does an asset manager inspire a potential client to trust him? The authors offer a range of suggestions, from the fragrance of hand cleansers in the washrooms of the asset manager’s offices to the trade-off between warmth and competence where “one additional unit of warmth, so to speak, will bring providers closer to a high-trust relationship than one additional unit of competence.”

The authors have struggled mightily to tease out the many strands in a trusting client-manager relationship. Ideally, we want to deal with someone who is, let’s say, talented, diligent, shares our values, and isn’t a jerk. But how do we rate these attributes? Are we willing to hire a less talented investment manager who isn’t a jerk over the jerk who is extremely talented? Probably. I assume that most asset management firms have already figured this out and keep their talented jerks hidden from public view. Or make them CEOs. (And, no, I won’t name names.)

Wednesday, April 11, 2018

Fraser, Class Matters

“Class matters in America precisely because the country has labored so hard to pretend it doesn’t.” This is the defining premise of Steve Fraser’s latest book, Class Matters: The Strange Career of an American Delusion (Yale University Press, 2018).

Fraser chose six icons of American history, none of which at first glance seems to have much to do with class, to frame his narrative: the settlements at Plymouth and Jamestown, the U.S. Constitution, the Statue of Liberty, the cowboy, the “Kitchen Debate” between Richard Nixon and Nikita Khrushchev, and the March on Washington and Martin Luther King’s “I Have a Dream” speech.

Here I’ll look briefly at the utopian view underlying the “Kitchen Debate.” At the American National Exhibition in Moscow in 1959, in the kitchen of a six-room suburban ranch house at the center of the exhibit that, it was claimed, “everyone in the United States could afford,” Vice President Nixon and Soviet Premier Khrushchev argued over “which society was likely to produce the best stoves, washing machines, televisions, electrical appliances, and other consumer delights.” The American Tomorrowland kitchen on display that year “promised to level the playing field between haves and have-nots.”

The notion of leveling was a common cultural theme at the time. One American magazine after the other touted the demise of social and economic classes. House Beautiful, for instance, wrote: “Our houses are all on one level, like our class structure.”

Admittedly, the post-war U.S. economy boomed, as did the country’s standard of living. A dominant view at the time was that “the modern corporation together with the welfare state worked to efface class. … Neither capitalist nor socialist, this new social species fused free-market liberalism with social democracy.”

But, even then, material well-being and social security were not universally available. “[A] whole phalanx of government housing programs, private-sector financing, local zoning protocols, and state and federal tax subsidies and shelters guaranteed that those options were really only practicable for families of more than modest means and of the right complexion. The suburban dream, like the American Dream more generally, turned out to be part real, part hallucination: class (and race) matter, no matter the efforts to make it go away.”

Sunday, April 8, 2018

Yardeni, Predicting the Markets

In one way or another every investor and trader predicts markets, even though some claim they’re not doing it and others decry the very attempt. Warren Buffett, for instance, famously said that “the only value of stock forecasters is to make fortune tellers look good.”

The economist Edward Yardeni, president of Yardeni Research, is a proud, self-described prognosticator. He calls his newly released, 600-page professional autobiography Predicting the Markets.

The book, which spans the author’s 40 years on Wall Street, ranges over geographies, socio-economic and business phenomena (technology and productivity, inflation, business cycles, consumers, demography), and markets (real estate, bonds, commodities, currencies, corporate earnings, valuation, stocks). The book itself contains no charts, a decision I applaud. Instead, the charts, and updated versions of them, are available on a companion website and are downloadable as .pdf files.

Yardeni has always grounded his prognostications in current analysis, which Ben Bernanke described as “getting an accurate assessment of the current economic situation, requiring a deep knowledge of the data mixed with a goodly dose of economic theory and economic judgment.” Throughout the book Yardeni explains the theory and judgment he brought to bear on relevant data to inform his predictions.

Yardeni is an old-school economist who claims never to have run a regression since his graduate school days. As a result, his book, though occasionally dense, is eminently readable by anyone with an interest in the interplay between economics and the financial markets over the years. No math background required.

Although Yardeni’s charts and the book’s final chapter bring his story up to date, one of the greatest contributions of this book is the historical context it provides to those economists and Wall Streeters who haven’t had such lengthy careers as the author. Perhaps even more important is the insight it offers into current analysis and the interplay among economic and market variables. In an obvious case, as Yardeni writes, “Predicting the stock market shouldn’t be all that difficult since only two variables drive it … -- earnings and the valuation of those earnings. But it’s tougher than it sounds, because both of those variables are driven by so many others.” Predicting the Markets connects a lot of dots.

Wednesday, April 4, 2018

Town, Invested

Danielle Town’s “12-month plan to financial freedom,” Invested: How Warren Buffett and Charlie Munger Taught Me to Master My Mind, My Emotions, and My Money (William Morrow, 2018), written with help from her bestselling author father Phil Town, is much better than the search-tag-filled subtitle would lead one to believe.

The setup is this: Danielle Town, a young lawyer, had always tuned out when her father, author of Rule #1 and a motivational speaker, had tried to get her to invest. But she eventually realized that, without investing, she would end up a wage slave for her entire life. And so, she finally decided to become her father’s student—and, having some of the entrepreneurial instincts of her father, to do a podcast of their conversations, and then to write a book based on these podcasts.

Danielle Town had two hurdles to overcome in order to become an active investor. First, she “was never one for numbers.” Second, and more devastating, she was terrified of investing. The first month in her 12-month plan thus dealt with “becoming brave.” Describing her fear, she writes: “I feel like I’m entering a dimly lit parking garage through an enclosed concrete stairwell with heavy doors at both ends, and I didn’t pack my pepper spray because it didn’t fit in my clutch and also I was afraid I would accidentally set it off in the crowded bar, and yes I had a few generously poured aged bourbons and still my radar is going off, saying, ‘Girl, don’t go into that concrete stairwell.’ … There are two types of people in the world—those who look at the Enclosed Concrete Stairwell and think nothing, and those who look at the Enclosed Concrete Stairwell and think, There’s a good possibility that this won’t end well for me. The first type is, more often than not, men; the second type is generally women. … [M]y instinctual reaction to the idea of investing in the stock market was GET THE HELL OUT OF THAT ENCLOSED CONCRETE STAIRWELL AND CALL AN UBER, IT’S WORTH THE SURGE PRICING.”

Even though Warren Buffett would probably have told her to put her money in an index fund, her father wanted her to get returns closer to Buffett’s than to the S&P 500. And she wanted to invest in companies whose mission and values she could support. So, in months two through twelve, she learned about value investing √† la Buffett and Munger, how to compile an antifragile portfolio, when to sell, and living thankfulness.

Invested is an inspirational book for the unwilling investor. Even though many people who read it will get only as far as buying an index mutual fund, it might speak to a new generation of potentially active investors as well. But those who are galvanized to invest on their own should understand that one book doth not a successful investor make. Nor, as Town points out, does one year. “There’s still a lot to practice.” And to learn.

Wednesday, March 28, 2018

Jensen, The End of Indexing

Niels Jensen’s The End of Indexing: Six structural mega-trends that will threaten passive investment (Harriman House, 2018) is a wonderfully thought-provoking book. It tackles macro issues that threaten not only passive investment but much active investment as well. Whether you agree with Jensen or not, and on most points it is hard not to, he will inspire you to rethink your long-term investing strategy.

The six mega-trends that Jensen analyzes are: the end of the debt super-cycle, the retirement of the baby boomers, the declining spending of the middle classes, the rise of the East, the death of fossil fuels, and mean reversion of wealth-to-GDP. No, he didn’t ignore automation; he just didn’t want to include it as a mega-trend because he wasn’t sure of its economic ramifications. And so it remains an important thread throughout the book but one with more questions than answers.

Jensen is a Dane based in London, the chief investment officer of Absolute Return Partners, which he founded in 2002. Although many of the charts he uses are based on U.S. data, he draws on trends from across the globe, contending that “all the structural trends in this book are global (or near global) in nature.”

Here I’ll take a quick peek at the last mega-trend, mean reversion of wealth-to-GDP. Jensen’s thesis is that “certain ratios have well established mean values, and the long-term mean value for US household wealth-to-GDP is about 3.8 times. In other words, if wealth-to-GDP is much different (as it is now), it will probably revert to the mean over time.” In recent history, the ratio hit 4.8 in 2000, fell back to 3.6 after the bear market of 2001-02, then went back up to 4.7 before getting decimated during the Great Recession, and as of the end of 2017 reached a whopping 4.9.

The wealth-to-GDP ratio can be understood as a capital-to-output (or capital efficiency) ratio, with wealth as capital and GDP as output. The lower the ratio, the more efficiently a country utilizes the capital at its disposal. So right now the U.S. isn’t using capital efficiently.

Total U.S. household wealth stands at $96.9 trillion; as of the end of 2017 U.S. GDP was $19.7 trillion. A return to the long-term mean of 3.8, assuming no significant change in GDP, would shave about $22 trillion off of household wealth. (In December 2008 U.S. household wealth troughed at $56 trillion, $41 trillion below the current figure.)

How should an investor structure her portfolio if she believes Jensen’s analysis? Jensen is a long-term investor, so he is not prescribing a short-term fix. In fact, he says, “if my recommendations work well in the near term, it will be down to luck more than anything else.” But, after reviewing four types of risk—beta, alpha, credit, and gamma—he is most inclined to focus on gamma risk. Examples of gamma risks are the factors (e.g., volatility, momentum, income, value, and size) in factor-based investing. The gamma risk factor offering the most attractive risk premium at the moment, he believes, is illiquidity risk, such as investing in music royalties.

I’ve barely skimmed the surface of Jensen’s book in this review. It merits reading and re-reading. And trying to take the other side of his arguments.

Sunday, March 25, 2018

Credit Suisse Global Investment Returns Yearbook 2018

Elroy Dimson, Paul Marsh, and Mike Staunton of London Business School and authors of Triumph of the Optimists (Princeton University Press, 2002) are responsible for the marvelous Credit Suisse Global Investment Returns Yearbook, now in its nineteenth annual edition. The yearbook was distributed to Credit Suisse clients and is not for sale to the general public, but a 40-page summary of the 251-page yearbook is available online.

The authors worked with 118 years’ worth of data. So this is no year in review; it’s 118 years in review, complete with myriad tables and graphs. Divided into five chapters, the yearbook covers long-run asset returns, risk and risk premiums, factor investing, private wealth investments, and 26 individual markets (23 countries plus world, world ex-USA, and Europe).

One of the questions the authors ask is whether equity premium is predictable. Using their long-run global database, they “adopt three approaches, each of which involves analyzing whether the equity risk premium (ERP) relative to bills in a particular year can help us to predict the annualized ERP over the subsequent five years.” They found, as one might expect, that “for strategic asset allocation, we learn relatively little (and nothing statistically significant) from recent annual performance about future equity premiums.” They conclude that “to forecast the long-run equity premium, it is hard to beat extrapolation that takes into account the longest history available when the forecast is being made.”

The authors also assess various forms of factor investing. Both over the long run and across different countries, size, value, income, momentum, and volatility have generated sizable premiums. But the authors write that “the theory of why such premiums should exist, or what types of risk they are rewarding, is admittedly weak. Furthermore, if they are generated by behavioral traits, behavior can change, especially as awareness of these factors—and their popularity—increases.”

Wednesday, March 21, 2018

Butman & Targett, New World, Inc.

Think back to what you learned in school about the first English settlers in America. Yes, the Jamestown settlement predated the Pilgrims’ arrival, but it never really captured our imagination. After all, Jamestown had a rocky time of it, with over 80% of the colonists dying in 1609-10. The moralistic storyline of the Pilgrims, however, became an integral part of our own national story. We learned that the Pilgrims had escaped religious persecution in England and (with their stay in the Netherlands often glossed over) decided to start a new colony in America, that they sailed on the Mayflower and landed (or probably didn’t) at Plymouth Rock.

What we didn’t learn about, except perhaps in passing, was that “even the Pilgrims, those paragons of virtue, were funded by merchants, entrepreneurs, business leaders—both great and modest—and were organized as a commercial enterprise. Without the funding and the backing of a business organization, albeit a badly managed one, the Pilgrims might never have left Leiden.”

New World, Inc.: The Making of America by England’s Merchant Adventurers (Little, Brown, 2018) by John Butman and Simon Targett recounts how, with both the crown and individual investors in dire need of new sources of revenue, the possibility of trade with faraway lands became alluring. The book begins about 70 years before the Pilgrims sailed, when England, “a relatively insignificant participant in world affairs,” faced “a daunting array of social, commercial, and political problems: rising unemployment, failing harvests, a widening gulf between rich and poor, and a crisis of leadership.” It was not certain whether the country could even survive.

But over the course of the next three generations “a constellation of remarkable people … emerged … to seek solutions to England’s ills.” Above all were the entrepreneurs who “masterminded a relentless stream of commercial enterprises dedicated to discovery, exploration, development, and settlement. … [T]hey organized, promoted, and supported hundreds of ventures, one after another, until multiple threads of failure began to stitch into a fabric of success. … They learned how to raise funding, share risk, and allocate capital in ventures with unpredictable outcomes. And most strikingly, they learned how to overcome seemingly insuperable challenges, accept and learn from failure, and cherish the quality that Americans have come to regard as quintessentially their own: perseverance.”

New World, Inc. is a fascinating account of both entrepreneurial risk-taking and the risk-taking of those men who set sail for unmapped destinations. The merchants often lost money; the sailors, their lives. And yet investors kept investing, sailors kept sailing.

One would like to say that Plymouth Colony was the vindication of all of these losses, but no. The Mayflower returned to England with nothing of value, and most of the investors eventually sold out of the Mayflower venture.