Michael Mauboussin, the Chief Investment Strategist for the well known fund manager Legg Mason, provides some interesting insights into the reasons why most investors perform poorly over time, and what are the key skills to develop for successful investing. He has written several books and is an adjunct professor of finance at Columbia University. He was interviewed recently by WealthTrack and I have summarised below the key points:
-While more hard work leads to better results in most spheres of life – it doesn't necessarily do so in the investment world where investors do too much and typically end up buying high and selling low. Often, sitting tight and not doing anything is the best course of action.
-Surveys of a variety of investor groups (including institutions) have shown that they typically hire managers who have recently outperformed and fire managers who have underperformed – and that they would have been better off over the following two year period if they had stayed with the underperforming managers.
-Investors suffer from a "recency bias" and their returns have lagged returns on mutual funds as they chase the hot funds of the day. The key is to find an asset which is unloved and cheap and then hold it (which is different from just buy and hold).
-Most activities in life lie somewhere along the continuum of pure skill, no luck and pure skill, no luck. Investing falls more towards the luck end of the spectrum, and that is why it is so hard to beat the market as everyone is working really hard at it and their skills sort of cancel out.
-It is therefore important to have longer time periods to assess managers (and strategies) as it is only then that their skills will be apparent. In the short term it tends to be noisy and luck plays a key role.
-Really good performances (or outcomes in other aspects of life) are usually a result of skills with lots of good luck – and luck tends to be transitory and mean reverting.
-There are three important skills to develop as an investor: 1) an analytical edge – which, firstly, requires the ability to analyse the difference between the price of an asset and its fundamentals, and, secondly, to position a portfolio appropriately by provide higher weightings to the good ideas , 2) behavioural - to avoid the traps and biases we are all prone to – i.e. over confidence and be overly swayed by market sentiments which tempts us to buy high and sell low, 3) institutional barriers – to avoid being with the pack.
-The well known value investor Seth Klarman of Baupost Group said it best: "Value investing is at its core the marriage of a contrarian streak with a calculator" implying that when everyone loves or dislikes something, take out your calculator and try to spot the discrepancy between the price and its fundamentals.
-The capital accumulation rate of a stock, which is determined by its price, is what matters to an investor. Dividend paying strategies only work if you assume that the dividends are fully reinvested with no taxes. For example, a sock worth $100 which pays a dividend of $3 is then worth $97 , and will be worth $100 only if you reinvest the full dividend.
-The market is currently attractively valued with the S&P500 estimated p/e for 2012 at around 12 versus a historical average of 15/16 – implying a yield of 8.3% which provides an excess return over treasuries of about 5%.
-US corporate balance sheets are healthy, and in particular the large multinationals are trading at attractive valuations and provide an attractive investment opportunity.
Thought provoking insights from Mauboussin and while we would all like to attribute our success to a superior set of skills – it is more often likely to be a result of luck! This is also the point made of Nassim Taleb in his book "Fooled by Randomness". Does this mean we give up working on our skill s? – of course not! – as he notes, luck is mean reverting, so developing your skill set and being prepared to take advantage of a favourable change in fortune would be an appropriate strategy. His observation on dividends is also instructive – dividend paying stocks have done well over long periods because the have also exhibited solid earnings growth, but the assumption underlying this thesis is that the dividends are reinvested and not spent! And on his final (and in my view) most important point, "be a contrarian with a calculator" – Greece and Tepco bonds anyone?!
With the abysmal job growth number released this Friday, the debate between austerity and further fiscal spending is likely to intensify in the weeks and months ahead. Talks of starting an infrastructure bank are an opening salvo from Obama – expect an acrimonious debate and more market volatility ahead. For those who continue to believe in the merits of fiscal austerity I would suggest listening to this 50 minutes lecture by Professor Paul Krugman delivered recently at Cambridge University to celebrate the 75th anniversary of the General Theory. To borrow an apt Sanskrit prayer from the Vedas: "tamaso maa jyotirgamaya" – "lead us from darkness to light"!
The timing on the earlier pronouncement that rating agencies may have found religion could not have been better. Not even an hour later, here comes Moody's with a blockbuster which may put China's "White Knight" status, at least as ar as Europe is concerned, in grave danger. In a report just released, the rating agency not only warns that China's debt problem is "bigger than stated" (i.e., China is hiding a ton of ugly stuff off the books), but goes ahead to quantify it: "Of the RMB 10.7 trillion (about $1.6 trillion) of local government debt examined by the Chinese audit agency, RMB 8.5 trillion ($1.3 trillion) was funded by banks. However, Moody's has identified another potential RMB 3.5 trillion ($540 billion) of such loans that the Chinese auditors did not discuss in their report….we find that the Chinese audit agency could be understating banks' exposures to local governments by as much as RMB 3.5 trillion." Naturally, the implication is that this is an absolutely willing "omission" (thank you central planning), which means that of China's $5.8 trillion GDP (or whatever imaginary number the Polit Bureau is happy with throwing around for mass consumption), $540 billion is debt that is "unaccounted for", most likely due to being, well, bad. That would be equivalent to saying that $1.4 trillion of US corporate debt is delinquent. And lest anything is lost in translation, Moody's drives the steak through the Dragon's heart: "Since these loans to local governments are not covered by the NAO report, this means they are not considered by the audit agency as real claims on local governments. This indicates that these loans are most likely poorly documented and may pose the greatest risk of delinquency." So let's get this straight: a country which has 10% of its GDP in the form of bad debt, is somehow expected to be credible enough to buy not only Greek debt, but the EURUSD each and every day? Mmmmk. In the meantime, Dagong downgrades the US to junk status in 5, 4, 3…
Full Moody's release:
"Moody's Investors Service says that the potential scale of the problem loans at Chinese banks may be closer to its stress case than its base case, according to an assessment that the rating agency conducted following the release of new data by China's National Audit Office (NAO).
When considering the apparent absence of a clear master plan to deal with this issue, Moody's also views the credit outlook for the Chinese banking system as potentially turning to negative.
"We assume that the majority of loans to local governments are of good quality, but based on our assessment of the loan classifications and risk characteristics, as provided by the NAO and other Chinese agencies, we conclude that the banks' exposure to local government borrowers is greater than we anticipated," says Yvonne Zhang, a Moody's Vice President and one of the authors of the report.
Of the RMB 10.7 trillion (about $1.6 trillion) of local government debt examined by the Chinese audit agency, RMB 8.5 trillion ($1.3 trillion) was funded by banks. However, Moody's has identified another potential RMB 3.5 trillion ($540 billion) of such loans that the Chinese auditors did not discuss in their report.
"When cross-examining the findings by the June 27 NAO report — in conjunction with reports from Chinese banking regulators — we find that the Chinese audit agency could be understating banks' exposures to local governments by as much as RMB 3.5 trillion," says Zhang.
"Since these loans to local governments are not covered by the NAO report, this means they are not considered by the audit agency as real claims on local governments. This indicates that these loans are most likely poorly documented and may pose the greatest risk of delinquency," the analyst adds.
Moody's report estimates that the Chinese banking system's economic non-performing loans could reach between 8% and 12% of total loans, compared to 5% to 8% in the rating agency's base case, and 10% to 18% in its stress case.
In the report, the rating agency examines various scenarios as to how banks could tackle problem loans, including some where the government provides assistance, but Moody's generally expects the Chinese authorities to implement gradual discipline.
Paul Krugman has written a fascinating review of a recent book : "Age of Greed: The triumph of Finance and the decline of America, 1970 to the present" by Jeff Maddrick. The book is a "deeply disturbing tale of hypocrisy, corruption and greed" and recounts, through a series of vignettes, how America came to be dominated by Wall Street and its culture of "greed is good" (the book is definitely on my ever expanding reading list!). To summarise:
-The recent crisis is the latest in a series of repeating cycles of "financial overreach, taxpayer bailout and subsequent Wall Street ingratitude". The busts only get bigger as it seems the lessons of past crises are not learnt.
-The US emerged from the Great Depression with a tightly regulated financial system which kept banking safe and boring for about 40 years.
-This began to change in the 1970s and 1980s as the political mood turned against "big government" largely as a result of the stagflation of the 1970s – which was not a result of "big government" but had its roots in temporary events like the oil price shock and disappointing crop yields which got magnified through wage-price indexation.
-Constant policy shifts under Nixon, Ford and Carter led to public disillusionment with government and proved to be a fertile ground for the antigovernment messages of Milton Friedman and Ronald Reagan.
-Reagan convinced a credulous public that the " government had become the principal obstacle to their personal fulfilment" and made excessive greed and individualism acceptable, and even lauded, in the American psyche.
-While Friedman made important contributions to the economic field, he often shoehorned real-life data to fit his views and made "overly simple assertions of free market claims". He erroneously believed that free markets were a solution to virtually every problem and even held the government responsible for the Great Depression (contrary to what the data says).
-Reagan and Friedman fanned the culture of "greedism– that unchecked self-interest furthers the common good".
-Walter Wriston, who ran Citibank from the 1960s until the 1980s, "lived a free market charade" arguing against the bailouts of Chyrsler (1978) and Continental Illinois (1984) while having his own bank saved by the government multiple times (sounds familiar?)
-Wriston was responsible for the first major step in banking deregulation with the introduction of negotiable CDs in 1961 which did away with the legal limits on deposits.
-Wriston also a played prominent role in the Latin American lending crisis of the 1980s and made the famous quote "Countries don't go bust" (which ranks with the Chuck Prince quote on "keep dancing until the music stops" as an all-time great!).
-The Latin American lending crisis has much in common with the sub-prime crisis decades later – i.e. a notion that all debtor nations (or nation-wide house prices) could not simultaneously have a funding problem (or suffer from precipitous price drops).
-US and European banks were bailed-out by the government with a programme heralded as aid to debtor nations but was in reality a bailout of the banks as the loans were made to the debtor nations to allow them to repay the banks, at the cost of imposing harsh austerity measures on the debtor nations which resulted in a "lost decade" for Latin America (sounds familiar?).
-Following the Latin American crisis was the savings and loan crisis of the early nineties, which had a greater direct cost to taxpayers than even the current crisis, and which was dealt with by further dismantling regulations left over from the Depression era.
-Then came the last two great bubbles – the technology bubble of the 1990s and the recent housing bubble, where Wall Street corruption played a crucial role and involved a colourful cast of characters: Sandy Weill, Jack Grubman (Solomon tech analyst), Frank Quattrone (Morgan Stanley tech banker), Ken Lay (Enron), Angelo Mozilo (Countrywide), Jimmy Caine (Bear Stearns) , Dick Fuld (Lehman), Stan O'Neal (Merrill Lynch) and Chuck Prince (Citibank).
-Sandy Weill was single-handedly responsible for dismantling the Glass-Steagal Act by proposing the merger between Solomon Smith Barney and Citibank, and actually getting the law changed to retroactively approve the merger.
-Abdication of regulatory oversight has been behind these cycles of financial overreach, crisis, bailout and lessons unlearnt. The centrepiece of this saga has been Alan Greenspan whose refusal to rein in the housing bubble, despite repeated warnings about an impending catastrophe, ranks highest in the list of ignominious acts. Greenspan, like Friedman and Reagan, firmly believed in "greedism" as an ethos.
-Why did this all happen? There are likely to be deeper forces at work than just a series of contingent event starting with the stagflation of the 1970s and roles played by the characters involved. The role of money in politics? A white backlash against the civil rights movement which transformed American politics? – a topic for another book.
-Despite the claims of some academics (primarily in business schools), the vast amount of capital channelled through Wall Street has not improved America's productive capacity by "efficiently allocating capital to its best use" and has in fact diminished its productive capacity through financial chicanery, massive bonus payouts and creating asset bubbles.
-The main lesson from these cycles , that unregulated greed, especially in the financial sector, is counterproductive for a nation's prosperity is still sadly unlearnt and we are still being told that "greed is good".
A remarkable narrative and a scathing criticism of the "greed is good" ethos which prevails today as a detriment against social and economical progress. A backlash against this culture is inevitable, and as noted by the socio-economist Neil Howe in book 'The Fourth Turning" the process is well underway. The pendulum swung to one extreme over the last few decades, ushering a radical shift in ideologies and beliefs in its wake, and will eventually swing to the other extreme and bring its own set of ideologies and beliefs. That is just how life and nature works-for better or for worse!
It was an eventful week in financial markets, with Greece voting in an austerity package which is likely to be followed by a EU vote this Sunday in favour of a funding package which would allow Greece breathing space until 2015. While the bonds are up in prices, they continue to provide an attractive yield and potential for further price appreciation as this issue gradually recedes into the background. As noted above, Latin America endured a decade of austerity to dig itself out of the hole and there is no reason that Greece, and other peripherals, cannot endure several more years of austerity to improve their balance sheets.
Select EM stock markets like Greater China, India, Brazil and Russia continue to provide an attractive entry level to add to the core EM assets position as the focus of these governments shifts from containing inflation to stimulating growth in the second half of the year. However, housing bubbles in some of these countries is likely to be contained as the backlash against unaffordable housing gains traction. I witnessed an unprecedented event in Hong Kong last night, with a late night silent sit-in by 218,000 people in central Hong Kong (which totally disrupted traffic and brought out scores of police vans!) protesting against government policies and unaffordable property prices. While HK/China property prices are unlikely to undergo a steep correction in the next few years (with China's change of regime taking place in 2012), they are likely to depreciate in real terms until a Renminbi revaluation (combined with a HK$ repeg) event takes place. The main beneficiary of this policy of containing housing prices is likely to be the stock market, which will benefit from the diversion of liquidity flows.
As a follow-up to last week's missive on the case for further fiscal spending as made by Larry Summers (which provoked some heated responses from readers!), I was pleasantly surprised to read Bill Gross of Pimco making a similar case. Bill Gross is a bond manager, and fiscal spending in anathema to bond investors and Wall Street bankers as it usually implies increasing interest rates which typically has an adverse affect on a variety of asset prices. Mr. Gross also highlighted the dire state of projected long-term finances of the US in a previous newsletter, so it is interesting to understand where he is coming from as he argues for more fiscal spending now and to focus on the long-term debt issue at a later stage. To summarise:
-The 2012 elections will be "fought on the battlefield of job creation". A 9.1% unemployment rate, which almost doubles if you include part-time and discouraged workers, does not create a well disposed electorate.
-Over the last 10 years, only 1.8 million jobs have been created while the workforce has grown by over 15 million. America's focus on services and hi tech sectors, and neglect of its manufacturing sector, has severely constrained its ability to create jobs.
-Over the past several decades, America's excessive reliance on financial assets to create wealth (and jobs) at the cost of an erosion of its manufacturing base, has finally led to a situation where the U.S. is "untrained, underinvested and overindebted" compared to its major competitors.
-Both the Democrats and Republicans have no credible plan on increasing employment – but both make claims that balancing the budget will, mystifyingly, create 20 million jobs over the next 10 years.
-Fiscal prudence is a long-term requirement for a stable and steady economy, but if implemented too quickly could be a death-blow to a still fragile economy.
-The roots of this false notion of fiscal conservatism equating to economic and job growth lie in the theories of David Ricardo developed in the early 19th century - which belong to the trash bin of theories aimed at academics rather than practical reality.
-Solutions to address the jobs issue should include long-term elements like education and skill-based training geared towards the "middle" than "hitech" , and more emphasis on science and math relative to the liberal arts. (He also makes some interesting observations on the state of college education in the US and questions whether it is worth the time and cost).
-The government needs to take the lead role in job creation – the private sector cannot take up this crucial role in the short-term as long as it is much cheaper to produce overseas with access to much labour.
-An infrastructure bank to fund reconstruction projects would be a productive use of deficit funds and a "true investment in our future".
-As the late economist and expert on financial crises Hyman Minsky noted so presciently years ago – "Big Government, should become the employer of last resort in a crisis, offering a job to anyone who wants one" .
An insightful piece which focuses on what will be the key issue as we move into 2012 – the lack of job growth in the US. With the economy growing at less than 3%, job creation will continue to be a challenge and will increase pressure on the Obama administration to provide more/continued stimulus – both on the fiscal and monetary front. The government should temporarily play a bigger role in the economy now to boost employment and growth, which would actually lay the groundwork for reducing fiscal imbalances in later years. As Professor Krugman has noted repeatedly in his columns- the US is in a zero-interest rate liquidity trap and conventional policies and frameworks to address issues like jobs and economic growth are unlikely to work– so now is not the time to "pay homage to some long defunct economist"!
I had noted the opportunity in purchasing Greece debt a few weeks ago, with short-term yields now over 30% and 5 year yields approaching 20% the opportunity continues to be attractive. The manager John Hussman made an interesting observation in his recent newsletter, that current market yields are implying a 100% chance of Greek default by mid-2013. This presents an attractive short-term investment (but risky!) opportunity as market sentiment possibly shifts over the next month or so– it is very unlikely that Greece will be allowed to default now as the contagion effects on the European financial system would make Lehman 2008 seem like a walk in the park! The long dated bonds (due 2037) are trading in the early 40s and likely present the best price appreciation potential.
