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.

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.”

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.

Botelho and Powell, The CEO Next Door

What are the four behaviors that transform ordinary people into world-class leaders? This is the question that Elena L. Botelho and Kim R. Powell ask and answer in The CEO Next Door (Currency / Crown Publishing, 2018). From a database of more than 17,000 CEOs and C-suite executives, they analyzed over 2,600 leaders. They coupled this analysis with 13,000 hours of interviews and two decades of experience advising CEOs and executive boards to distill the common attributes of successful CEOs.

The CEO Next Door is divided into three sections. The first hundred pages deal with the book’s leading question. Then come 60 pages on how to get a CEO job and 80 pages on navigating the challenges of the role. Here I’ll touch on only the first section, titled “Get Strong: Master the CEO Genome Behaviors.”

Those who reach the top are decisive, opting for speed over precision. They engage for impact, understanding exactly who their stakeholders are and what they want. They exhibit relentless reliability, delivering consistently. And they adapt boldly, riding the discomfort of the unknown. These behaviors, it is important to stress, are not inborn traits but habits shaped by practice and experience.

Decisive CEOs, the authors not unexpectedly found in their study, were twelve times more likely to be high performers. So, what are the keys to being an effective decision maker? Three things stand out: making decisions faster, making fewer decisions, and putting in place practices to get better at decision making.

I’ll skip the next two behaviors to get to the fourth, adapting boldly. “The best leaders,” the authors tell us, “thrive in a condition of relentless discomfort, adapting their organizations and themselves. These CEOs chart new paths before they have to, not when there’s no other choice. … They take the attitude, If I am not uncomfortable, then I am probably not learning or changing fast enough.”

Adaptive CEOs are willing to let go of approaches that have worked before. Otherwise, their companies may end up like Kodak, where in 1975 a young engineer developed a digital camera but the company did nothing with it, or Blockbuster, which had three chances to buy Netflix.

The authors illustrate their points with stories about and interviews with CEOs.

Mayer-Schönberger and Ramge, Reinventing Capitalism in the Age of Big Data

Businesses are facing their most formidable challenge in decades: a shift from firms to data-rich markets which, in turn, will upend traditional, money-based ones. These transformations are the focus of Reinventing Capitalism in the Age of Big Data (Basic Books / Hachette, 2018) by Viktor Mayer-Schönberger and Thomas Ramge. The authors “connect the dots between the difficulties faced by traditional online markets; the error of the stock market’s trusted pricing mechanism; and the rise of markets rich with data.” They “argue that a reboot fueled by data will lead to a fundamental reconfiguration of our economy, one that will be arguably as momentous as the Industrial Revolution, reinventing capitalism as we know it.” That’s a bold claim, one not yet borne out but here and there showing some proverbial green shoots.

The most basic difference between markets and firms is “the way information flows and is translated into decisions, and by whom. This is reflected in their structures: the market mirrors the flow of information from everyone to anyone and the decentral decision-making by all market participants, [whereas] the hierarchical firm mirrors information streaming to its center, where leaders make the key decisions.”

Markets may offer the potential for greater information for everyone, but traditional markets tend to be reductionist. They translate the full gamut of preference information into an information trickle around price. But recent advances in data-handling, which themselves are founded on data, are improving our ability to choose based on data. For example, BlaBlaCar “allows riders and drivers to get matched along multiple dimensions, including their self-reported level of chattiness…. With less opportunity for negotiating on price, riders are more likely to take other information into account when selecting a ride.”

What will this reconfiguration of our economy mean for the financial markets? The authors argue that more money is now available for capital investments and fewer companies are looking it, which means that returns on investment will plummet. “This spells the end of finance capitalism as we know it…. The economy will thrive, but finance capital not with it; it epitomizes the shift from money-based markets to data-rich ones.” The authors continue: “data-rich markets devalue money, and investors will be paying the bill. … If there is reassurance to be had, it is that although data-rich markets will cause a drastic shock to the system, with thousands of billions of dollars in individual holdings evaporating as rates of return drop and investments lose their value, this shock will likely be one-time, rather than recurring. Once capital has been devalued and our expectations of the anticipated returns from it are reset, capital’s value will likely hold steady, rather than continue to slide.” And “in the long run, … data-rich markets will help investors to better identify opportunities that match their preferences and are less clouded by human bias. … We’ll still need financial advice, but it will likely come from a machine rather than a human being.”

Whether or not you follow the authors all the way to financial Armageddon (I personally find their hypothesis about finance capital unconvincing), their book is a stimulating read.

Shenq and Hong, Value Investing in Asia

I can’t begin to guess how many feet of library shelves it would take to house all the books that have been written on value investing. The best answer is probably “too many.” So do we need yet another one? Yes. Value Investing in Asia by Stanley Lim Peir Shenq and Cheong Mun Hong (Wiley, 2018) takes the value investor into uncharted waters, waters rife with dangers but with the potential for solid profit.

The authors offer general, somewhat eclectic, guidelines to screen for companies that may be worth investing in. More important, however, as they stress, is knowing what not to invest in. They highlight both financial and non-financial red flags. Among the financial red flags are abnormally high margins, trade receivables growing faster than revenue, inventory growing faster than revenue, consistent excessive fair value gains, companies in a dilutive mood, leverage, and seemingly unnecessary borrowings. Among the non-financial red flags are massive reshuffling of the company’s officers, infamous directors and shareholders, when things vanish into thin air (e.g., a fire destroys a company’s books and financial records or a truck carrying five years of financial documents is stolen—the truck is later recovered but not the documents), and “innovative” business deals.

Five case studies illustrate the way the authors invest, each with a unique “hook”: value through assets, current earning power, growth through cyclicality, special situation, and high growth (Tencent).

The book concludes with five interviews with Asian fund managers. There’s also some online bonus content.

Investors who are thinking about buying individual Asian stocks would do well to read this book, not so much as a value investing primer but as an Asian investing primer.

Schilling, Quirky

What makes some people spectacularly innovative? This is the question that Melissa A. Schilling addresses in Quirky: The Remarkable Story of the Traits, Foibles, and Genius of Breakthrough Innovators Who Changed the World (PublicAffairs/Hachette, 2018. Although the book’s title is catchy, the answer is not that they’re quirky (though most of them were/are—as are millions of people who are not at all innovative).

Schilling focuses on eight innovators—Benjamin Franklin, Thomas Edison, Nikola Tesla, Marie Curie, Albert Einstein, Steve Jobs, Dean Kamen, and Elon Musk—and looks for significant commonalities.

Although superior intelligence is insufficient to make someone a serial breakthrough innovator, exceptional creativity is likely to be more common in the presence of high intelligence. Working memory may be the link between the two. “In my work modeling cognitive insight as a network process, I showed that individuals who are more likely or more able to search longer paths through the network of associations in their mind can arrive at a connection between two ideas or facts that seems unexpected or strange to others.” Moreover, as a result of exceptional working memory and executive control, highly creative people can do this much more quickly than less creative people. Tesla and Musk are textbook examples. “Both men had such extraordinary cognitive power that they were able to process a long path of calculations almost instantly in their heads. Their conclusions appear to arrive almost by magic!”

Innovators tend to exhibit high levels of social detachment and extreme faith in their ability to overcome obstacles. They work tirelessly, often at great personal cost, and many are driven by idealism. They also benefit from situational advantages conferred by time and place—and luck.

Based on the characteristics of the eight innovators she studied, Schilling makes some recommendations for nurturing “the innovation potential that lies within us all.” No, she isn’t offering a formula for creating the next Einstein. As she notes, “The life of the serial breakthrough innovator is not for everyone.” But we can tap some of their traits, such as separateness, even if we ourselves don’t crave to be socially detached. And we can improve people’s situational advantages.