To me, the idea of placing too much emphasis on benchmarking in the short term is ill founded and adds to informational noise which in turn causes irrational behaviour. Trying to magically outperform something that is uncontrollable over the short term kind of signals to me that there are some serious misunderstandings in what is trying to be achieved. In the short term it is inevitable that we may underperform the market and it should be expected. Until we can accept this can we then, and only then start to understand how to beat the market. As I have written before, an investment process is one which works over the long term by the fact that the process is weighing the probabilities in the user’s favour. As with the coin flipping example in the “Process vs Outcome” post, it is only once we give the process a chance can we start to realise the probabilities associated with the process - over the long term.
Thursday, 27 December 2007
Indexes
When thinking about performance, it’s interesting to note what we are trying to compete against. In most cases our benchmark is some kind of index or basket of indexes. So how are the constituents of an index chosen? For example the FTSE All Share index is basically a market capitalisation weighted index of the largest 350 stocks trading on the London Stock Exchange. There is low turnover and no human decision. The S&P 500 is determined based on several non human factors such as Liquidity, Four Quarters of Positive Net Income, Market Cap, Sector Representation and Lack of Representation. However, despite their simplicity the majority of fund managers have trouble beating these benchmarks. Which leads me t ask, are we doing something wrong and if so what is it?
To me, the idea of placing too much emphasis on benchmarking in the short term is ill founded and adds to informational noise which in turn causes irrational behaviour. Trying to magically outperform something that is uncontrollable over the short term kind of signals to me that there are some serious misunderstandings in what is trying to be achieved. In the short term it is inevitable that we may underperform the market and it should be expected. Until we can accept this can we then, and only then start to understand how to beat the market. As I have written before, an investment process is one which works over the long term by the fact that the process is weighing the probabilities in the user’s favour. As with the coin flipping example in the “Process vs Outcome” post, it is only once we give the process a chance can we start to realise the probabilities associated with the process - over the long term.
To me, the idea of placing too much emphasis on benchmarking in the short term is ill founded and adds to informational noise which in turn causes irrational behaviour. Trying to magically outperform something that is uncontrollable over the short term kind of signals to me that there are some serious misunderstandings in what is trying to be achieved. In the short term it is inevitable that we may underperform the market and it should be expected. Until we can accept this can we then, and only then start to understand how to beat the market. As I have written before, an investment process is one which works over the long term by the fact that the process is weighing the probabilities in the user’s favour. As with the coin flipping example in the “Process vs Outcome” post, it is only once we give the process a chance can we start to realise the probabilities associated with the process - over the long term.
Tuesday, 25 December 2007
Process vs. Outcome
Enterprise software development is a discipline in which process is often a deciding factor between success and failure. In my experience, more often than not projects run over time and over budget which I would put down primarily to one thing, focussing on the outcome of the project rather than focussing on the process of achieving the outcome. Through desperation, most managers falsely believe that adding more developers will help. Instead deadlines slip further. Getting developers to work longer. Instead deadlines slip further. Emergency measures whatever they may be. Yet deadlines still slip further. In other words, most software projects are conquered with brute force rather than careful thought and finesse. Instead of concentrating on eating the carrot, why not first work out how to get the carrot.
As anyone who has thought about software development for what it is can tell you, the complex relationships between understanding client requirements and technical complexity are difficult. Only when the actual process of the software development process is addressed are development teams enabled to start building malleable and flexible software that meets business and technical requirements. What needs to be understood is how software that is malleable and flexible in its design is cheaper to maintain, easier to build and less problematic overall. Only with a disciplined process can this result be achieved. Unfortunately, the brute force approach nearly always creates software that is late, over budget, barely satisfies the business requirements. Moreover, a long term legacy of difficult and expensive maintenance is born. This approach of focussing on the outcome rather than the process behind the final outcome comes down to our need for instant gratification regardless of long term results. It’s the feel good factor that drives us. When projects are faced with challenges a well defined process does not instantly lead to better results but in aggregate it does and this is why most people continue to carry on with the brute force approach. It’s the average speed, not maximum speed that counts.
To me, it is pretty clear that investing is not much different from software development in its need for process. Process brings to the table a set of disciplines that are not available with a “gut feeling” approach. To consistently repeat logical decisions a well defined process must be in place. Sustainability of execution is the all important. However, it is important to realise that even with a “superior” process we will not be guaranteed against failure. What we will see is a lower chance of failure. We are just moving the odds further into our favour. Over the long term, we will see an stronger aggregate result.
We are seriously limiting our chance of success by focussing on the short term. As investing is a probabilistic endeavour it can not reasonably be expected that a process will lead to a desired result every time. Coin tossing is a useful analogy of how long term results revert back to a process mean. A toss of a fair coin obviously has a 50% chance of heads and a 50% chance of tails. If coin is flipped twice is this going to be an indicative of these probabilities? The chances of flipping two heads or two tail are pretty high (25%). However the more times the coin is flipped the closer our results will be 50% heads, 50% tails. This is the mean of our process and over an extended set of outcomes it can logically be assumed. In other words, this is “the law of large numbers”.
An investment process is exactly the same. If you only give it a limited chance to work then the chances that you will be disappointed are high. You are not moving the odds into your favour because you are forgetting about the law of larger numbers. Accepting that there will be periods of under performance and that the aggregate results are what count. There is no such thing as “the law of small numbers”.
As anyone who has thought about software development for what it is can tell you, the complex relationships between understanding client requirements and technical complexity are difficult. Only when the actual process of the software development process is addressed are development teams enabled to start building malleable and flexible software that meets business and technical requirements. What needs to be understood is how software that is malleable and flexible in its design is cheaper to maintain, easier to build and less problematic overall. Only with a disciplined process can this result be achieved. Unfortunately, the brute force approach nearly always creates software that is late, over budget, barely satisfies the business requirements. Moreover, a long term legacy of difficult and expensive maintenance is born. This approach of focussing on the outcome rather than the process behind the final outcome comes down to our need for instant gratification regardless of long term results. It’s the feel good factor that drives us. When projects are faced with challenges a well defined process does not instantly lead to better results but in aggregate it does and this is why most people continue to carry on with the brute force approach. It’s the average speed, not maximum speed that counts.
To me, it is pretty clear that investing is not much different from software development in its need for process. Process brings to the table a set of disciplines that are not available with a “gut feeling” approach. To consistently repeat logical decisions a well defined process must be in place. Sustainability of execution is the all important. However, it is important to realise that even with a “superior” process we will not be guaranteed against failure. What we will see is a lower chance of failure. We are just moving the odds further into our favour. Over the long term, we will see an stronger aggregate result.
We are seriously limiting our chance of success by focussing on the short term. As investing is a probabilistic endeavour it can not reasonably be expected that a process will lead to a desired result every time. Coin tossing is a useful analogy of how long term results revert back to a process mean. A toss of a fair coin obviously has a 50% chance of heads and a 50% chance of tails. If coin is flipped twice is this going to be an indicative of these probabilities? The chances of flipping two heads or two tail are pretty high (25%). However the more times the coin is flipped the closer our results will be 50% heads, 50% tails. This is the mean of our process and over an extended set of outcomes it can logically be assumed. In other words, this is “the law of large numbers”.
An investment process is exactly the same. If you only give it a limited chance to work then the chances that you will be disappointed are high. You are not moving the odds into your favour because you are forgetting about the law of larger numbers. Accepting that there will be periods of under performance and that the aggregate results are what count. There is no such thing as “the law of small numbers”.
Friday, 7 December 2007
Moving From Target Returns to Expected Returns
Investing is really just a probabilistic endeavour not unlike gambling. Lets think about that for a moment. Like gambling, investing has a set of expected outcomes and like gambling, the only certainty is that there is no certainty. However, despite this lack of certainty we need to act.
For precise prediction, we rarely have the required information and by adding more information we do not necessarily obtain more accurate results. To counter this we need to look at decision making as a set of probabilistic outcomes. By calculating a probability distribution we can arrive at an expected value which takes into account probable chances of loss. In other words the chance of an adverse result. In total this will enable us to calculate an expected return rather than a target return. This is no different from producing a decision tree of probabilistic outcomes.
By expressing opinions in expected value terms we are admitting that there may be a chance of a negative result. By reviewing all of the scenarios (good, bad and neutral, etc) we can start to think of the payoffs and the probabilities of those payoffs. It removes the risk of focusing too much on particular scenarios (often the positive ones). In behavioural finance this is known as "anchoring"- if we start to think of the target return for of a certain stock we start to look for evidence that will support that target whilst dismissing contrary information.
By considering multiple scenarios, we are enabled psychologically to consider all the available information. This allows us to enter into the investment position with the idea that there may be an unfavourable result. In other words, we can be wrong without a fear of failure.
So what does all of this mean? Lets take a look at an example.
Stock exceeds earnings target. 25% probability. Stock rises by 3%
Stock meets earnings target. 50% probability. Stock rises by 1%
Stock misses earnings target. 25% probability. Stock falls by 4%
(0.25 x 3% + 0.50 x 1% + 0.25 x -4%) = 0.25%
We can see here that our expected return is not really all that favourable, even though the probability is clearly in favour of a positive result. Lets look at an even more illustrative example.
Stock exceeds earnings target. 25% probability. Stock rises by 3%
Stock meets earnings target. 65% probability. Stock rises by 0.5%
Stock misses earnings target. 10% probability. Stock falls by 10%
(0.15 x 3% + 0.65 x 0.5% + 0.20 x -10%) = -1.225%
This is clearly a bullish outlook but the expected return is negative. So what should we do? Short sell?
Now lets look at a typical stock which is facing some problems. Each piece of bad information gives us a small reduction in the price but any positive information has a big impact (upwards) on the price. Lets look at an example:
Stock exceeds earnings target. 25% probability. Stock rises by 15%
Stock meets earnings target. 50% probability. Stock rises by 0.5%
Stock misses earnings target. 25% probability. Stock falls by 2%
(0.25 x 15% + 0.35 x -0.5% + 0.50 x -2%) = 2.575%
Again, the odds are not in favour of a positive outcome but the expected value is positive. Look past the frequency of success and start thinking about the expected value. It's not the frequency of being correct that matters; it's the magnitude of being correct that matters. These are simple examples just used to illustrate a point but remember that through investing, we are dealing in a probabilistic endeavour so it needs to be asked "are target returns really that relevant"?
For precise prediction, we rarely have the required information and by adding more information we do not necessarily obtain more accurate results. To counter this we need to look at decision making as a set of probabilistic outcomes. By calculating a probability distribution we can arrive at an expected value which takes into account probable chances of loss. In other words the chance of an adverse result. In total this will enable us to calculate an expected return rather than a target return. This is no different from producing a decision tree of probabilistic outcomes.
By expressing opinions in expected value terms we are admitting that there may be a chance of a negative result. By reviewing all of the scenarios (good, bad and neutral, etc) we can start to think of the payoffs and the probabilities of those payoffs. It removes the risk of focusing too much on particular scenarios (often the positive ones). In behavioural finance this is known as "anchoring"- if we start to think of the target return for of a certain stock we start to look for evidence that will support that target whilst dismissing contrary information.
By considering multiple scenarios, we are enabled psychologically to consider all the available information. This allows us to enter into the investment position with the idea that there may be an unfavourable result. In other words, we can be wrong without a fear of failure.
So what does all of this mean? Lets take a look at an example.
Stock exceeds earnings target. 25% probability. Stock rises by 3%
Stock meets earnings target. 50% probability. Stock rises by 1%
Stock misses earnings target. 25% probability. Stock falls by 4%
(0.25 x 3% + 0.50 x 1% + 0.25 x -4%) = 0.25%
We can see here that our expected return is not really all that favourable, even though the probability is clearly in favour of a positive result. Lets look at an even more illustrative example.
Stock exceeds earnings target. 25% probability. Stock rises by 3%
Stock meets earnings target. 65% probability. Stock rises by 0.5%
Stock misses earnings target. 10% probability. Stock falls by 10%
(0.15 x 3% + 0.65 x 0.5% + 0.20 x -10%) = -1.225%
This is clearly a bullish outlook but the expected return is negative. So what should we do? Short sell?
Now lets look at a typical stock which is facing some problems. Each piece of bad information gives us a small reduction in the price but any positive information has a big impact (upwards) on the price. Lets look at an example:
Stock exceeds earnings target. 25% probability. Stock rises by 15%
Stock meets earnings target. 50% probability. Stock rises by 0.5%
Stock misses earnings target. 25% probability. Stock falls by 2%
(0.25 x 15% + 0.35 x -0.5% + 0.50 x -2%) = 2.575%
Again, the odds are not in favour of a positive outcome but the expected value is positive. Look past the frequency of success and start thinking about the expected value. It's not the frequency of being correct that matters; it's the magnitude of being correct that matters. These are simple examples just used to illustrate a point but remember that through investing, we are dealing in a probabilistic endeavour so it needs to be asked "are target returns really that relevant"?
Monday, 19 November 2007
Blogging is Simple But Not Easy
I haven't written anything for a while. Actually, I haven't written for months. I was pretty busy with my wedding late this summer and the start of the course has been pretty hectic.
Blogging has actually been pretty good. By trying to articulate my ideas I've found that I have developed a much stronger understanding of the things I've written about. But I'm going to try and pump out some more posts over the next months.
Blogging has actually been pretty good. By trying to articulate my ideas I've found that I have developed a much stronger understanding of the things I've written about. But I'm going to try and pump out some more posts over the next months.
Monday, 2 July 2007
Speculation vs. Investment
"An investment operation is one which, upon thorough analysis, promises safety of principle and a satisfactory return. Operations not meeting these requirements are speculative.... An investment operation is one that can be justified on both qualitative and quantitative grounds." Security Analysis, Graham & Dodd, 1951 Edition
Defining the term investment is somewhat difficult as most people have their own understanding of what it means to invest their money. As a simple example, we probably can all agree that investing £50,000 in a business and subsequently receiving an annual income from the business of £10,000 can be classed as an investment. In the world of financial markets the definition of an investment is not as clear cut. It is quite clear that there is often no real distinction between speculation and investment in this arena.
Generally speaking, speculation could be defined as bad and investment could be defined as good. When looking at these definition in such simple terms the distinction between the two becomes far more obvious. However in financial markets how can we tell what is good and what is bad? Before going any further, it would be fair to say that before an investor starts to invest his money this is a distinction that should be clearly understood. In any case, the failure of investors to understand this difference is what caused the disastrous dot com mania and its subsequent crash.
Keep in mind that just because a security may be seen as low risk does not mean that it is not possible to speculate. For example, on one hand take the large purchase of a particular bond issue in anticipation of a quick rise in price. This speculative behaviour turns an otherwise "safe" investment into something more risky. On the other hand, just because a security is perceived as a higher risk does not mean that it can not be classed as an investment. Take for instance the purchase of a relatively smaller cap stock trading at below its intrinsic value. The very fact that the stock trades below its calculated intrinsic value creates a price buffer, associated with the purchase at that price. This price buffer is otherwise known as a margin of safety and serves to somewhat protect the investor against large losses associated with the purchase.
It is this margin of safety that offers an indication to the definition of what could be termed as an investment. Using the two previous examples, this concept can only really be useful when the purchase of a security is done using more than psychological factors. What is needed in the purchase of an investment is a set of repeatable standards that can assist the investor gauge the amount of safety associated any given opportunity. It is important to realise that for any given security, the purchase may be classed as an investment at one price but not at another. Again, understanding the margin of safety principle makes this obvious.
Although not investments, a basic everyday analogy is the purchase of an article of clothing in the week before Christmas compared to the week after Christmas when the sales are on. We are paying two completely different prices for exactly the same product. This shows that when the price is right we obviously get better value for our money. Investing is no different. It's all about buying at the right price.
Determining the investment worth of any given security is not a precise science. Moreover, it is something that, even with careful analysis, is different for every situation. It will however still offer reasonable protection against loss under all "likely" conditions. What is important is that the definition of the process that is used determine the real worth of a security, and whether to go ahead with the investment, is backed up with a well defined yet flexible valuation strategy. Taking into account the price and the quality of security is all part of this strategy.
As the level of chance in a given investment increases, the value of analysis starts to decrease. One of the underlying problems with speculative investments is that they are susceptible to sudden price corrections. Even though the intrinsic value of an investment of less speculation can change before it is reflected in the market price, this problem becomes even more pronounced as an investment becomes more speculative.
To quote Graham and Dodd's 1951 edition of Security Analysis, investments can be broken down into four different types:
are very different and I think that it should be immediate that the second form could be likened to gambling. When investing, we would ultimately be aiming to ensure that the investments that we do make fall under the category of being analyst's investments. Otherwise, money not held under this category could arguably be classed as one of the two forms of speculation.
Defining the term investment is somewhat difficult as most people have their own understanding of what it means to invest their money. As a simple example, we probably can all agree that investing £50,000 in a business and subsequently receiving an annual income from the business of £10,000 can be classed as an investment. In the world of financial markets the definition of an investment is not as clear cut. It is quite clear that there is often no real distinction between speculation and investment in this arena.
Generally speaking, speculation could be defined as bad and investment could be defined as good. When looking at these definition in such simple terms the distinction between the two becomes far more obvious. However in financial markets how can we tell what is good and what is bad? Before going any further, it would be fair to say that before an investor starts to invest his money this is a distinction that should be clearly understood. In any case, the failure of investors to understand this difference is what caused the disastrous dot com mania and its subsequent crash.
Keep in mind that just because a security may be seen as low risk does not mean that it is not possible to speculate. For example, on one hand take the large purchase of a particular bond issue in anticipation of a quick rise in price. This speculative behaviour turns an otherwise "safe" investment into something more risky. On the other hand, just because a security is perceived as a higher risk does not mean that it can not be classed as an investment. Take for instance the purchase of a relatively smaller cap stock trading at below its intrinsic value. The very fact that the stock trades below its calculated intrinsic value creates a price buffer, associated with the purchase at that price. This price buffer is otherwise known as a margin of safety and serves to somewhat protect the investor against large losses associated with the purchase.
It is this margin of safety that offers an indication to the definition of what could be termed as an investment. Using the two previous examples, this concept can only really be useful when the purchase of a security is done using more than psychological factors. What is needed in the purchase of an investment is a set of repeatable standards that can assist the investor gauge the amount of safety associated any given opportunity. It is important to realise that for any given security, the purchase may be classed as an investment at one price but not at another. Again, understanding the margin of safety principle makes this obvious.
Although not investments, a basic everyday analogy is the purchase of an article of clothing in the week before Christmas compared to the week after Christmas when the sales are on. We are paying two completely different prices for exactly the same product. This shows that when the price is right we obviously get better value for our money. Investing is no different. It's all about buying at the right price.
Determining the investment worth of any given security is not a precise science. Moreover, it is something that, even with careful analysis, is different for every situation. It will however still offer reasonable protection against loss under all "likely" conditions. What is important is that the definition of the process that is used determine the real worth of a security, and whether to go ahead with the investment, is backed up with a well defined yet flexible valuation strategy. Taking into account the price and the quality of security is all part of this strategy.
As the level of chance in a given investment increases, the value of analysis starts to decrease. One of the underlying problems with speculative investments is that they are susceptible to sudden price corrections. Even though the intrinsic value of an investment of less speculation can change before it is reflected in the market price, this problem becomes even more pronounced as an investment becomes more speculative.
To quote Graham and Dodd's 1951 edition of Security Analysis, investments can be broken down into four different types:
- Business investment - Referring to money held in a business.
- Financial investment or investments generally - Referring to securities generally.
- Sheltered investment - Referring to securities regarded as subject to small risk by reason of their prior claim on earnings or because they rest upon adequate taxing power.
- Analyst's investment - Referring to operations that, upon thorough study, promise safety of principal and an adequate return.
- Intelligent speculation - the taking of a risk that appears justified after careful weighing of the pros and cons.
- Unintelligent speculation - risk taking without adequate study of the situation.
are very different and I think that it should be immediate that the second form could be likened to gambling. When investing, we would ultimately be aiming to ensure that the investments that we do make fall under the category of being analyst's investments. Otherwise, money not held under this category could arguably be classed as one of the two forms of speculation.
Friday, 22 June 2007
Real Estate
Consider the current economic environment where interest rates have recently been slowly increasing and may continue to do so in the foreseeable future. They may go down but it's unlikely. Now imagine borrowing £1,000 at 10% to buy a bond selling at a premium yielding 9% hoping that the 1% you are losing in interest payments will be offset by appreciation of the bond price in subsequent years due to what you hope will be lower future interest rates. Keep in mind that as interest rates go up, bond prices go down in order to create a higher yield to match the interest rate. Would you do it?
This is just a made up scenario that to me seems both speculative and risky. I don't think that any rational and well advised retail investor would ever do something like this. The risk reward ratio would just not be worth it. However, in my opinion this route is similar to the one which many property investors here in the UK have decided to take.
I recently heard about someone who has taken out an interest only mortgage on an "investment" property where the monthly rental income falls £25 per month short of the monthly mortgage repayments. And this is not including any capital expenditures. Not only is there is a highly leveraged position, some the bank's interest charges out of this person's own pocket just to keep the investment alive under the false premise that property prices will continue rising forever. Keep in mind there is an interest only mortgage which is not amortising the loan. As I’m told, because there is a leveraged position in the investment, any price appreciation will magnify any gains on the initial investment but I think there are two things being missed:
It's true that rent inflation will see the £25 monthly deficit disappear within a couple of years however this may take longer than anticipated if interest rates continue to increase. Moreover, if interest rates do continue to rise then that puts pressure on market price appreciation- the entire point of this investment.
There is nothing wrong with real estate as an investment as the old adage "safe as houses" still holds true in my opinion. However this style of "investment" is incredibly sensitive to any market down turn. The strange thing is that my colleague feels perfectly comfortable with the situation. I wonder what the feeling will be if, heaven forbid, the market slowed and declined enough to see her "investment" fall into a negative equity situation. What if prices were to stagnate for 10 years? What if there was forced sale? If one can afford to ride out any market storms then they will be OK in the long run but whether they will be wealthier for it I can not say. Without amortising the loan there is an even greater risk of seeing negative equity in the purchase.
I want to finish this post by citing one interesting comment made by Warren Buffet which went along the lines of "one of the characteristics of a price bubble is that investors start to invest in assets based on price appreciation alone and forget about the income generated by the asset". I think that pretty much sums it up.
This is just a made up scenario that to me seems both speculative and risky. I don't think that any rational and well advised retail investor would ever do something like this. The risk reward ratio would just not be worth it. However, in my opinion this route is similar to the one which many property investors here in the UK have decided to take.
I recently heard about someone who has taken out an interest only mortgage on an "investment" property where the monthly rental income falls £25 per month short of the monthly mortgage repayments. And this is not including any capital expenditures. Not only is there is a highly leveraged position, some the bank's interest charges out of this person's own pocket just to keep the investment alive under the false premise that property prices will continue rising forever. Keep in mind there is an interest only mortgage which is not amortising the loan. As I’m told, because there is a leveraged position in the investment, any price appreciation will magnify any gains on the initial investment but I think there are two things being missed:
- Leverage cuts both ways. Borrowing five times the deposit will see a 10% rise in the market price return a 50% return on the investment. On the flip side, a 10% drop in the investment will give a 50% drop in the investment.
- Vitally, she is not receiving any productive economic benefit from this "investment". Instead she sees the speculative appreciation in the property price. Isn’t this the same as hoping to gain from trading commodities? Read more here
It's true that rent inflation will see the £25 monthly deficit disappear within a couple of years however this may take longer than anticipated if interest rates continue to increase. Moreover, if interest rates do continue to rise then that puts pressure on market price appreciation- the entire point of this investment.
There is nothing wrong with real estate as an investment as the old adage "safe as houses" still holds true in my opinion. However this style of "investment" is incredibly sensitive to any market down turn. The strange thing is that my colleague feels perfectly comfortable with the situation. I wonder what the feeling will be if, heaven forbid, the market slowed and declined enough to see her "investment" fall into a negative equity situation. What if prices were to stagnate for 10 years? What if there was forced sale? If one can afford to ride out any market storms then they will be OK in the long run but whether they will be wealthier for it I can not say. Without amortising the loan there is an even greater risk of seeing negative equity in the purchase.
I want to finish this post by citing one interesting comment made by Warren Buffet which went along the lines of "one of the characteristics of a price bubble is that investors start to invest in assets based on price appreciation alone and forget about the income generated by the asset". I think that pretty much sums it up.
Monday, 18 June 2007
Commodities Are Not Investments.
It's not hard to believe the strong economic case for the growth in commodity prices in the years ahead. With emerging economies like China and India coming online the world's supply of various raw materials to support their development is under pressure, hence pushing commodity prices up. I certainly see the reasoning behind it and I believe that it will happen.
However, I don't want to invest in commodities even though I believe in the story behind them. Why? Because commodities are not investments. They are links to economic production. They have no cash flows so they create no value related to any future productive enterprise. Also, as there is no possibility of any future cash flows how can I discount their value back to a present value today? Other than discounting the final cash flow when it comes time to sell there is no real value created to me as an investor that makes them difficult to value. Obviously the only real way to make money on a commodity transaction is if the price has gone up when it comes time to sell. But there is no way to really place a value on how much and how this price will occur.
Of course, this argument is not isolated to commodities. I would not class derivatives (futures, swaps, forwards, options etc, etc) and currencies as investments because, like commodities, they do not create any future value. They merely shift wealth from one side to the other. In other words, there is no win-win situation; there is only a win-lose situation where one person "wins" a pound at the expense of another person losing a pound. As an example, Stocks on the other can create wealth for all those involved. Consumers receive a marginal benefit from the products they purchase, employees receive benefit through their salary and investors receive a benefit through economic profit.
However commodities, derivatives and currencies do have their place in the area of risk managment. This was was the original motivation behind many derivative products. For an example read more here
So if the purchase of a commodity is not an investment then what is it? I can only conclude that commodity purchases are merely speculative- no matter how much research and thought go into the decision to buy (or sell). Commodity purchases can really only rely on macro economic information which is general at best and pricing information which is provided by the general sentiment of the market (which as any investor who has experienced a market correction knows this can change quickly). How can an investor have any fair degree of confidence to reasonably predict where the intrinsic value and margin of safety lies when we have nothing to quantify against?
As an someone who works at a large commodity hedge fund in London told me, the January 2007 commodity market recorrection was the most stressful periods of his life. Not a very nice way to spend a skiing holiday in France. Maybe if the nature of his "investments" were a little more like real investments then maybe he wouldn't have had as much to worry about.
However, I don't want to invest in commodities even though I believe in the story behind them. Why? Because commodities are not investments. They are links to economic production. They have no cash flows so they create no value related to any future productive enterprise. Also, as there is no possibility of any future cash flows how can I discount their value back to a present value today? Other than discounting the final cash flow when it comes time to sell there is no real value created to me as an investor that makes them difficult to value. Obviously the only real way to make money on a commodity transaction is if the price has gone up when it comes time to sell. But there is no way to really place a value on how much and how this price will occur.
Of course, this argument is not isolated to commodities. I would not class derivatives (futures, swaps, forwards, options etc, etc) and currencies as investments because, like commodities, they do not create any future value. They merely shift wealth from one side to the other. In other words, there is no win-win situation; there is only a win-lose situation where one person "wins" a pound at the expense of another person losing a pound. As an example, Stocks on the other can create wealth for all those involved. Consumers receive a marginal benefit from the products they purchase, employees receive benefit through their salary and investors receive a benefit through economic profit.
However commodities, derivatives and currencies do have their place in the area of risk managment. This was was the original motivation behind many derivative products. For an example read more here
So if the purchase of a commodity is not an investment then what is it? I can only conclude that commodity purchases are merely speculative- no matter how much research and thought go into the decision to buy (or sell). Commodity purchases can really only rely on macro economic information which is general at best and pricing information which is provided by the general sentiment of the market (which as any investor who has experienced a market correction knows this can change quickly). How can an investor have any fair degree of confidence to reasonably predict where the intrinsic value and margin of safety lies when we have nothing to quantify against?
As an someone who works at a large commodity hedge fund in London told me, the January 2007 commodity market recorrection was the most stressful periods of his life. Not a very nice way to spend a skiing holiday in France. Maybe if the nature of his "investments" were a little more like real investments then maybe he wouldn't have had as much to worry about.
Saturday, 16 June 2007
Tulipmania and Mr. Market
First lets start with Mr Market, a classic investment analogy first explained in Bejamin Graham's book, The Intelligent Investor. The story goes something like this:
Imagine you own part of a business in partnership with a person named Mr. Market. Every day he tells you what your share of the business is worth and offers to buy your portion of the business or sell you an additional interest in the business. His views on the business swing from an incredible optimism to an overwhelming pessimism and anywhere in between. With this in mind the prices that he offers you gyrate as often as his moods do. When Mr Market quotes an incredibly high price, you might sell some of your stake in the business (or all of it if the price is right) whereas if the price he quotes you is low enough, you might decided to buy some of his stake (or all of it). However, any time the price is not right you don't have to do anything other than wait until he quotes you a price you are satisfied with based on your own ideas of what the business is worth.
This is such a simple explanation of the investment environment that we are in yet I wonder why so many investors fail to take this advice? Why any investor would sell a holding based on a declining stock price (i.e. stop losses) when the underlying "story" behind the investment has not really changed is hard to understand from a logical perspective. I often wonder whether this is because investors do not really understand what they are investing in and why.
However, I do understand that loss aversion and the games that it plays with your mind can get pretty intense at times. Even in the best case scenario, when there is a strong criteria driven business reason behind the investment, the thought of a declining stock price can make you want to sell. On the other hand, when there are a less than sound criteria behind an investment decision, a declining stock price can be hard to stomach.
Think about any investment where you felt there was a larger than normal element of speculation involved in the decision. When the price goes down on these speculative investments the first reaction is to SELL! The natural instinct against loss aversion starts to kick in. Without a set of real quantifiable investment criteria there is no way to measure the investment's price action against market events. Having this set of criteria will help to allow you to avoid investing based on emotions, tips, rumours and other psychological based biases. in other words, not knowing the underlying story behind a business and it's fundamentals gives an you very little psychological cushioning for seeing the investment through to the point where you realise the original reason for the investment in the first place.
To illustrate my point further, here’s a classic story about investor irrationality during the 1600s and the sad consequences for many of those involved. It kind of rings like the euphoric mania behind the internet stock bubble.
Tulipmania
Imagine you own part of a business in partnership with a person named Mr. Market. Every day he tells you what your share of the business is worth and offers to buy your portion of the business or sell you an additional interest in the business. His views on the business swing from an incredible optimism to an overwhelming pessimism and anywhere in between. With this in mind the prices that he offers you gyrate as often as his moods do. When Mr Market quotes an incredibly high price, you might sell some of your stake in the business (or all of it if the price is right) whereas if the price he quotes you is low enough, you might decided to buy some of his stake (or all of it). However, any time the price is not right you don't have to do anything other than wait until he quotes you a price you are satisfied with based on your own ideas of what the business is worth.
This is such a simple explanation of the investment environment that we are in yet I wonder why so many investors fail to take this advice? Why any investor would sell a holding based on a declining stock price (i.e. stop losses) when the underlying "story" behind the investment has not really changed is hard to understand from a logical perspective. I often wonder whether this is because investors do not really understand what they are investing in and why.
However, I do understand that loss aversion and the games that it plays with your mind can get pretty intense at times. Even in the best case scenario, when there is a strong criteria driven business reason behind the investment, the thought of a declining stock price can make you want to sell. On the other hand, when there are a less than sound criteria behind an investment decision, a declining stock price can be hard to stomach.
Think about any investment where you felt there was a larger than normal element of speculation involved in the decision. When the price goes down on these speculative investments the first reaction is to SELL! The natural instinct against loss aversion starts to kick in. Without a set of real quantifiable investment criteria there is no way to measure the investment's price action against market events. Having this set of criteria will help to allow you to avoid investing based on emotions, tips, rumours and other psychological based biases. in other words, not knowing the underlying story behind a business and it's fundamentals gives an you very little psychological cushioning for seeing the investment through to the point where you realise the original reason for the investment in the first place.
To illustrate my point further, here’s a classic story about investor irrationality during the 1600s and the sad consequences for many of those involved. It kind of rings like the euphoric mania behind the internet stock bubble.
Tulipmania
Thursday, 7 June 2007
Value
Value investing - the disciplined practice of buying assets that trade for less than their intrinsic value in an effort to gain from their long term performance. Intrinsic value? This could basically be defined as the current discounted value of the future cash flows of a business.
As an investment style, I think that value investing can be defined by the following:
An understanding of how markets are efficient
In reality only 50% of investors can beat the market so it is important to understand that by and large markets are "generally" efficient. By understanding and recognising irrational investor behaviours an investor can begin to understand how to succeed in stock market investing. However, it is fair to say that markets are not totally efficient as can be simply displayed by the periodic market corrections that we are all so familiar with.
An ability to invest with long term investment horizons
To paraphrase Ben Graham, "In the short run, the market is a voting machine, but in the long run it is a weighing machine." Understanding this simple principle enables an investor to ride out the stock market gyrations thrown at us by Mr Market. It is probably fair to say that in the short run the stock market is pretty efficient. However as most investors have relatively short term investment views, this opens up the gate to long term pricing inefficenies which can be found by investors who are prepared to wait for the market to catch up.
An ability to understand the intrinsic value of a business and to buy into that business at a realisable discount to that value
Being able to evaluate the real fundamental intrinsic value underpinning a business and then finding the opportunity to pay well below this value in order to own a piece of the business creates what is commonly known as a margin of safety. Think of it as buying £2 for £1. Moreover, an investor must have some way of searching for this value out of the universe of available investments. It would be far too time consuming for an investor to search through everything so there must be a way to screen stocks to narrow down this universe.
In combination I think these three elements give an investor a powerful set of "tools" in which to make investment decisions. However, I can't see how any one of these three skills is particularly effective when used in isolation. The old adage "fail to plan, plan to fail", is particularly important here. By producing some sort systematic methodology for investment an investor may more than likely satisfactory returns. Unfortunatly there is no exact science to it so in the beginning a lot of it is going to come down to trial and error.
As an investment style, I think that value investing can be defined by the following:
An understanding of how markets are efficient
In reality only 50% of investors can beat the market so it is important to understand that by and large markets are "generally" efficient. By understanding and recognising irrational investor behaviours an investor can begin to understand how to succeed in stock market investing. However, it is fair to say that markets are not totally efficient as can be simply displayed by the periodic market corrections that we are all so familiar with.
An ability to invest with long term investment horizons
To paraphrase Ben Graham, "In the short run, the market is a voting machine, but in the long run it is a weighing machine." Understanding this simple principle enables an investor to ride out the stock market gyrations thrown at us by Mr Market. It is probably fair to say that in the short run the stock market is pretty efficient. However as most investors have relatively short term investment views, this opens up the gate to long term pricing inefficenies which can be found by investors who are prepared to wait for the market to catch up.
An ability to understand the intrinsic value of a business and to buy into that business at a realisable discount to that value
Being able to evaluate the real fundamental intrinsic value underpinning a business and then finding the opportunity to pay well below this value in order to own a piece of the business creates what is commonly known as a margin of safety. Think of it as buying £2 for £1. Moreover, an investor must have some way of searching for this value out of the universe of available investments. It would be far too time consuming for an investor to search through everything so there must be a way to screen stocks to narrow down this universe.
In combination I think these three elements give an investor a powerful set of "tools" in which to make investment decisions. However, I can't see how any one of these three skills is particularly effective when used in isolation. The old adage "fail to plan, plan to fail", is particularly important here. By producing some sort systematic methodology for investment an investor may more than likely satisfactory returns. Unfortunatly there is no exact science to it so in the beginning a lot of it is going to come down to trial and error.
Lean Investing
"Lean" is a theory that has revolutionised how many organisations manage their processes. The origins of lean thinking started with Toyota, the japanese auto manufacturer. During the 1940's, the company needed a way a way to cheaply manufacture cars - After the war, people did not have much money, let alone money for expensive cars. The question for Toyota was how could they keep production volumes low whilst at the same time keeping the cars as cheap as mass-produced cars?
From this dilemma emerged the ideas that formed the foundations of the Toyota Production System (TPS) that forms the basis of the lean models that we have today. The basic ideas behind being lean are simple- eliminate waste and concentrate on what works.
Toyota was able to greatly reduce lead times and cost using the TPS, while improving quality at the same time. Moreover, lean has enabled Toyota to become one of the ten largest companies in the world. It is currently as profitable as all the other car companies combined and Toyota became the world's largest car manufacturer in 2007. Lean has also been used with great success in the software development world so it is viable for more than just manufacturing cars. For a more information on the beginnings of lean see:
Wikipedia Page on the TPS
Mary Poppendieck's Articles on Lean
What has lean got to do with investing and asset management? When taking a holistic view of the investment management process, from the asset manager to the end client, lean may be an effective way to increase the profits for the portfolio manager whilst continuing to be ethical and loyal to the end client.
As a discipline and by its very nature, value investing lends itself very well to the ideas behind lean. For example the ideas of infrequent trading and portfolio concentration are both ideas that reduce the problems associated with market timing, stock selection/analysis costs, transaction costs. As an investment manager, costs equal waste so this is a natural area to address. Although simplistic, this may form the basis for possible appications of lean principles in investment management.
From this dilemma emerged the ideas that formed the foundations of the Toyota Production System (TPS) that forms the basis of the lean models that we have today. The basic ideas behind being lean are simple- eliminate waste and concentrate on what works.
Toyota was able to greatly reduce lead times and cost using the TPS, while improving quality at the same time. Moreover, lean has enabled Toyota to become one of the ten largest companies in the world. It is currently as profitable as all the other car companies combined and Toyota became the world's largest car manufacturer in 2007. Lean has also been used with great success in the software development world so it is viable for more than just manufacturing cars. For a more information on the beginnings of lean see:
Wikipedia Page on the TPS
Mary Poppendieck's Articles on Lean
What has lean got to do with investing and asset management? When taking a holistic view of the investment management process, from the asset manager to the end client, lean may be an effective way to increase the profits for the portfolio manager whilst continuing to be ethical and loyal to the end client.
As a discipline and by its very nature, value investing lends itself very well to the ideas behind lean. For example the ideas of infrequent trading and portfolio concentration are both ideas that reduce the problems associated with market timing, stock selection/analysis costs, transaction costs. As an investment manager, costs equal waste so this is a natural area to address. Although simplistic, this may form the basis for possible appications of lean principles in investment management.
The Lean Investor
This blog has been started as a simple way to document and arrange my thoughts on investing whilst at the same time putting my thoughts up for public scrutiny. The main topics which will be covered are:
Value
Portfolio concentration, longer term investment horizons, margin of safety.
Small/Micro Cap Companies
Generally companies trading on London's Plus and AIM exchanges. These companies are often illiquid and perceived as risky due to their large standard deviation of returns.
Special Situations
Companies undergoing significant structural changes. For example, spin-offs, restructurings, mergers, bankruptcies, etc.
Market Inefficiencies
Pricing anomilies. The price of the asset is below what would normally be expected.
I'm afraid I won't be offering any stock tips or market commentaries as I feel a blog is not really the appropriate place for such information.
Value
Portfolio concentration, longer term investment horizons, margin of safety.
Small/Micro Cap Companies
Generally companies trading on London's Plus and AIM exchanges. These companies are often illiquid and perceived as risky due to their large standard deviation of returns.
Special Situations
Companies undergoing significant structural changes. For example, spin-offs, restructurings, mergers, bankruptcies, etc.
Market Inefficiencies
Pricing anomilies. The price of the asset is below what would normally be expected.
I'm afraid I won't be offering any stock tips or market commentaries as I feel a blog is not really the appropriate place for such information.
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