Wednesday, October 18, 2017

Howard Mark's recent G & D interview quotes

I enjoy reading the Graham-Doddsville newsletter.

Some pertinent quotes, relating to the issue of indexing and quantitative/AI factor.

Howard Marks:

“If people take their money out of active management, then active managers would fire all their analysts, and then the market would not stay efficient. Then the necessary condition is satisfied for active to work. The point is, I don't think this move is permanent, I think it's rotational.”

“Because every dollar that goes into a truly passive fund is invested on autopilot, the fund must buy the stocks that satisfy its criteria, and that’s without regard to value. That suggests to me that prices can go farther in diverging from value before they get corrected. Think about what would happen if 95% of the money went into index ETFs or index funds. Who would be setting prices? There’s something called price discovery, and it’s done by thoughtful buyers and sellers. The price of a security in the marketplace is set by buyers and sellers coming together, and seeing if they can find a place to transact where the buyer thinks it has good upside, and the seller thinks it doesn’t. Who provides that function if all the buying are on autopilot? People put their money in index funds, with the presumption that they’re minimizing error, but how much of your money do you want to have managed in a fund where nobody’s thinking about the price of the stocks or the weightings within the portfolio? The thing about investing is that the efficient market hypothesis says that price equals value. Active management is about the assumption that price sometimes deviates from value, finding those deviations, and then taking advantage of them. It seems to me that the fewer the people who are looking at value, the higher the likelihood that price can diverge from value. But that’s just a hypothesis.”

“None of this stuff is easy. The greatest quote in my book is from Charlie Munger, who said, “None of this is meant to be easy, and anybody who thinks it’s easy is stupid.” All this stuff is really complex. It’s easy to talk about, but it’s hard to implement. How do you tell the ones who are good but unlucky, from the ones that are bad? It’s not easy. It takes judgment. That’s why I believe that this whole thing can never be completely computerized, because I think exceptional investment success requires judgment, and I don’t know if AI can be taught to make those judgments.”

Dear readers, any thoughts?

Yours One-Legged

Thursday, September 14, 2017

Book Review: Big Money Thinks Small

Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing (Columbia Business School Publishing) by [Tillinghast, Joel]

An interesting read. In terms of concepts and philosophies, the reader will not find anything new that was not encountered before if one has been constantly reading up on the topic of investment.

The author ties together concepts of value investing augmented with experiences and practical applications of financial history and behavioural psychology. The main takeaway for me is his account of the travails of Dendreon and the dangers of investing in a "story." To summarise, Dendreon was a biotech which developed a treatment for cancer. The main bull story for Dendreon was that once FDA approval is obtained, earnings will rocket to the sky. The ending was that Dendreon did actually obtain FDA approval, and its share price went up tenfold, however sales were disappointing and the company eventually declared bankruptcy!

There are several stocks on the ASX in which investors are clearly enamoured with the "story", the most vivid example being Mesoblast.

The author also addressed the issues inherent in indexing, factor investing and macro investing.

The only gripe I have with the book is that it could be better organised. The way it was written looks more like a stream of thought cobbled together hastily without any overarching framework.

A reminder that there is a library of my reading here.

Enjoy and prosper
Yours One-Legged

Thursday, July 13, 2017

Book Review: Priceless

This is a very entertaining and easy read. Not much prior background knowledge required, but you will gain a lot more insights if you do.

Specifically relevant to investing, you will gain an insight as to why price trends occur in all markets, how and why market bubbles form, and how/why this has and will repeat themselves.

The reversal preference experiments show clearly why many investors (including myself) hang on to losses and cut their winners too early.

The anchoring and adjustment experiments will be known to many of us. However, I think many will miss the essential lesson- being that anchoring and adjustment is an artifact of guessing. With investing, there will always be a degree of guessing, so the challenge is to be able to deal with effects of anchoring and adjustment.

Enjoy and Prosper
Yours One-Legged

Tuesday, May 16, 2017

Musings on Passive Investing via Index Funds

The Basic Proposition

As per Buffett and Munger, Indexing makes sense if you do not know what you are doing. In aggregate, active managers cannot achieve a result better than the index. In fact, given the extreme skewness of the stockmarket, it is virtually guaranteed that over a long period of time, a majority of active managers will never do better than the index, especially after deduction of significant fees. Given that all long term records of stockmarkets show an upward trend, it makes sense to be invested in the whole market rather than betting on its discrete elements, especially if the attendant costs/fees involved are much lower.

The Problems

The first problem with indexing is that the market is self-correcting, and too much of a good thing becomes a crowded trade. Indexing becomes a problem when too much money is chasing after it. If this happens, prices are no longer tethered to values, and you will have a situation where asset prices rise purely because they are rising and vice versa. This means that asset prices no longer reflect actual business performance, which is unsustainable. Conceptually, index funds are intended to passively track the index. However, if too much funds are involved, the fund inflows by themselves will have a significant effect on the index levels. Index funds will no longer be passively tracking the index, rather, they would be a major factor affecting the index.

The second problem with indexing is the wide sweeping assumption that everything tends to average. An often used marketing angle of index funds is that a majority of fund managers cannot beat the market.  This is true, but it fails to address the main issue of how to select a fund manager who is capable of beating the market. A system with average values will often have wide non-random variability between its system participants. There are persistent winners, and there are persistent losers. Try to remember the kid that always comes first in class over your entire experience of primary and secondary school. And don’t forget the one that comes consistently last. We ask ourselves why? In every field of endeavour, there is a pecking order which is inviolate, and the top and bottom can often be identified very early in advance. Proponents of indexing sweep this away under the carpet.

The third problem with indexing lies with its basic proposition that equity markets inevitably rise over time, ostensibly at a steady rate of 7% per annum. This is true over a truly long time span, say 60-100 years. The reality is that market returns in discrete periods fluctuates greatly. The following are US Equity returns during the Post-War period:
1946-2012 6.4%
1946-1965 10%
1966-1981 -0.4%
1982-1999 13.6%
2000-2012 -0.1%

An investor invested in index funds in the year 2000 would have had made a loss over the next 12 years. The critical message- unless your investment horizon is truly long term over at least 50 years, there is no guarantee that index funds will do well.

The Consequence

Human behaviour and the power of incentives will ensure that so long as investors want salt, they will be sold salt. It is not in the best interest of promoters and managers to sell a single index fund where investors are encouraged to stay invested indefinitely with no churn. If there is no activity and no churn, how are they going to earn their bread? Marketers know the basic behavioural problems of average investors and they will act accordingly, leading to a proliferation of different ETFs.

Investors want choices because each of them believes they are above average investors able to make superior choices than the average punter- hence a proliferation of ETFs will be created to satisfy this demand. If enough people want an ethical ETF which promotes social notions such as gender equality or white supremacy, then the market will surely create this ETF to satisfy demands. Given that the average investor is also unable to sit still and clamor action, there will be plenty of different ETFs to satisfy the need for action.

Investors are also greedy, so leveraged ETFs are created to turbo-charge returns. After all, over the long term, the sharemarket only ever rises.  Investors are also envious creatures. They will not be happy with a steady 7% per annum with a vanilla index fund when their neighbours are raking in 15% from the latest triple leveraged ETFs. Leveraged ETFs will then be in hot demand. 

As investors race up the risk curves, the market will continue to create products to satisfy this demand. Pretty soon, derivatives of ETFs will be created, and then further derivatives. They will all be marketed with great endorsement and validation- virtually assured returns with very little risks involved- whilst the promoters rake in fees and bonuses.

Does this sound familiar to you?  How would all these end?

The Solution?

In the tradition of Fermat, I am nearly finished with my suggested solution, but [insert suitable excuse].

Stay tuned. 

Yours One-Legged

Wednesday, May 10, 2017

Xero Follow-Up

Xero published its full year report today, so it is time to update our figures. The following table summarises the salient metrics:


R & D




Once again, the figures are headed in the right direction. Cash burn is still $71m, with $114m left in the bank, implying a steady runrate of 1.5 years. 

As a matter of comparison, let's look at Intuit's 2016 metrics:

Revenue USD$4.7billion up 12% from 2015 (note: XRO growth is 44%)
COGS 16% of revenue
R & D 19% of revenue
General 11% of revenue
Marketing 28% of revenue
Total 74% of revenue

The current market cap for XRO is roughly NZ$3.2 billion. Still too rich for my taste. As a matter of comparison, Intuit's market cap is currently USD$33 billion, trading on a historical PE of 33.

Tuesday, May 9, 2017

Stock Picking and Reality

I am currently gathering my thoughts on the current hot issue of passive investing via index funds. I have written quite a lengthy article which is not quite ready for publication yet.

This short blog post will appear to be another nail in the coffin for active investing.

It is not intended to be.

The main purpose of this post is to point out that the truth, as usual, is rather more nuanced than the black and white propositions presented daily in the press.

If you are a stock-picker or aspiring to be one, then it is imperative to understand the monstrous task required. Stock returns over the long term are extremely skewed. Crazily so. Studies of the US market appear to indicate that only 4% of stocks accounted for the entire market gain over the period starting from 1926 to 2015.

The relevant blog post with the article link is here.

These means that a randomly generated portfolio (the monkey dart theory) will fail to beat the market 99% of the time. It is now also easier to understand why active management, in aggregate, cannot beat the market. In fact, it is a logical inference that when the active management industry, in aggregate, gets larger and larger, it is doomed to fail in its collective quest to beat the market. That is likely to hold true even if we disregard fees.

It does make the case for passive indexing even stronger.

But that is not the entire story. Stay tuned.

Yours One-Legged

p/s astute readers will get a hint from the above. Just as nature abhors a vacuum, the market appears to abhor a crowded trade.

Tuesday, May 2, 2017

Book Review- Where Good Ideas Come From

My brief thoughts on reading this book:

New ideas arise from a synthesis of ideas, usually from unrelated disciplines. They do not just come out from a vacuum.

Connection of ideas within a body of ideas require a reasonably large body of ideas to start with, and the body of ideas must continually expand, hence requiring continuous learning.

But since the existing store of human knowledge is so vast, we. need to pick our spots. Distant ideas are more difficult to connect than adjacent ideas. Looking back, most if not all of my profitable ideas arose because of a synthesis of prior work. 

Relates back to circle of competence.