Thought Bubbles from the Deep

[DeepState]

Duration (as in interest rate sensitivity) is very important for long term equity selection, especially at the moment with interest rates so low. High duration stocks (little pricing power, big current asset bases) – banks spring to mind - seem overpriced too me unless interest rates don’t move up for a long time. Duration margin seems negative in the equities market to me at the moment. However some of the lower duration stocks are much more attractive from a long term perspective. One of the few opportunities left in this time of financial suppression.

Basically the negative duration premium in equities makes the yield chase occurring now dangerous but still leaves opportunities for buying long term growth at a reasonable price.

Without voicing disagreement about the points made on interest rate sensitivity, the concept of duration as applied to equities when the phrase 'duration on XYZ stock' is used is calculated as per a bond. However, instead of coupons/capital, the FCF to equity owners or Dividends are used in making the determination. Hence, it is possible for an equity holding to be very long duration in circumstances where the company does not carry any debt at all.

I do not know of anyone who prices along an implied discount rate/duration curve in equities. I have only seen the calculation done once in the wild.

In this context, we can think of duration as the marginal change in the valuation of a stock for a small change in the discount rate implied from the FCF/DDM forecasts and current price. The longer the duration, the more sensitive it is to changes in the discount rate.

 

[CanOz]

I guess there is more to life than QE... The positioning is based around questions like 'Would I hold this position for 20 years?' and 'Would that be a stupid thing to do?' The proposal of just EU, given it is embarking on QE, is quite tactical in nature. Markets are weird. Sometimes bad news is treated as good news...and then it changes for reasons that only become clearer afterwards. I am just trying to look through all of that for the most part without being totally ignorant of current circumstances. The record of successful market timing is utterly shocking, especially given how much robust commentary is released on it all day long. I'm not playing that game if it is not necessary to do so. I have no edge there.

Understand, makes sense. Thanks for the reply.

I'm gathering it's just not that simple either. I have a small position in a European ETF, given the meteroic rises of the Japanese and US equity markets after the QE programs, it seems like a trade I may work my way into. That's why I asked.

Thanks for the thread, reading with great interest.

CanOz

 

[DeepState]

Understand, makes sense. Thanks for the reply.

I'm gathering it's just not that simple either. I have a small position in a European ETF, given the meteroic rises of the Japanese and US equity markets after the QE programs, it seems like a trade I may work my way into. That's why I asked.

Thanks for the thread, reading with great interest.

CanOz

Things to stress test your thinking:

+ When Fed entered QE, equity markets subsequently ran as you noted.
+ The US is far more financially deep in terms of wealth in the form of securities hence the portfolio channel of QE is stronger. This is a point heavily noted by the ECB as a reason why the EZ version will be less potent.
+ In the US the interest rates were compressing from what, now, look like high levels.
+ The US actually cleaned up its banking system. It also has far more market friendly rules and regulations, including those related to labour, to let the QE effects flow to the real economy. This is not the case in Japan and the EZ.
+ In Japan, after the announcement shock of QQE wore off, the Nikkei 225 didn't do a heck of a lot (in AUD) between then and the big increase in the program size in Oct 2014 which included coordinated action from GPIF. Hence, beware of the currency impacts. Also beware that Japan policy makers waltzed into the equity markets directly in a very serious way.
+ In the ECB, the rates are already super low before QE even began and the announcement was well anticipated for months. The equity market has already rallied hard into it. The ECB is not planning to buy equities. The portfolio effect will be weaker due to the lower level of securitization of assets and lower equity culture. The European banking system is still vulnerable to sovereign risk at a time when the sovereigns of Italy, Spain and France are really in quite some strife were it not for their credit risk being borne by the ECB and mutualized as a result to a degree. QE increases moral hazard for political reform in the EZ, to an extent which is probably larger than for the US or Japan.

There are design features of the ECB program which also make it less effective as QE within a monetary union with various details in the way the ECB can buy stuff works differently to QE in a single sovereign.

This is worth reading:

Keynote speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, at the
City of London Corporation, London, 12 February 2015.

The above are just to highlight things where the EZ set-up differs from the Japanese and US experience. QE doesn't work identically across these places. These details can matter in forming your inferences for a repeat performance.

 

[DeepState]

Just realized I turned 1,000 today!! :dance: :alcohol:

 

[CanOz]

Just realized I turned 1,000 today!! :dance: :alcohol:

Congratulations DeepState! A great 1000 posts as well...

I for one have been much enlightened by your presence on ASF, hope you continue!

CanOz

 

[KnowThePast]

Just realized I turned 1,000 today!! :dance: :alcohol:

Happy Birthday!

Likewise, I have been reading all your posts with great interest and look forward to the next 10000.

 

[burglar]

Just realized I turned 1,000 today!! :dance: :alcohol:

Yay!

 

[galumay]

Yep, a valuable contribution to ASF and a very high ratio of interesting, informative and challenging posts!

I have to admit I struggle to understand more than about 50% of what you are talking about - which reflects on me rather than you!

Always enjoy trying to understand your posts and improve my own limited knowledge!

 

[Faramir]

Congratulations. Thank you for your reply earlier.

 

[fiftyeight]

Good work. Love this thread and your posts in general.

Most of it is way over my head but I understand just enough to find it super interesting. I will be keen lurker of this thread

 

[qldfrog]

Congratulation indeed, one of the most interesting input in the ASf for my interests.
Just wishing I could be more a discussion partner and be able to debate whereas the truth is I am the pupil/apprentice
Respect!

 

[tech/a]

Macro Economics a favorite topic and one of the few books I'll search out.

Just haven't had the time to join (read research and make sense) in and hold court with ASF resident Professor of Economics.

QE seems at least in the short term allow economies to sort out their spending---
As pointed out each different.
Japan resisted it and paid the price in stagnation.
The US had no choice with credit default swaps all but busting the system.
EU and the PIGS all languish in the "How" of supporting their QE resting on the hope that stimulation will bring surplus to their mismanaged economies. Take Greece---you cant have a Social Security policy if you don't have a taxation system to support it.

Even so in each situation the inevitable is being hidden.
You cant wage wars,supply health care,prop up stupidity in the Financial and domestic sector all the while spending more than you earn and just expect the consequences to disappear as the printing presses roll!

Default has and will continue to happen if Govts world wide don't live within their means---which few wish to do.
Bonds will become Junk.

Perhaps the pepper's who predict anarchy arent that crazy!

 

[craft]

(My bold above)

craft - when you say "current" do you mean ....

as in 'now' - not the accounting definition - sorry for the confusion.

Without voicing disagreement about the points made on interest rate sensitivity, the concept of duration as applied to equities when the phrase 'duration on XYZ stock' is used is calculated as per a bond. However, instead of coupons/capital, the FCF to equity owners or Dividends are used in making the determination. Hence, it is possible for an equity holding to be very long duration in circumstances where the company does not carry any debt at all.

I do not know of anyone who prices along an implied discount rate/duration curve in equities. I have only seen the calculation done once in the wild.

In this context, we can think of duration as the marginal change in the valuation of a stock for a small change in the discount rate implied from the FCF/DDM forecasts and current price. The longer the duration, the more sensitive it is to changes in the discount rate.

I think of equity duration much more along these lines than what might be the text book definition of equity duration. I find it makes much more intuitive sense and for me is a major consideration in long term stock selection.




Thanks for mentioning equity duration - appreciated prompt for me to ponder again an important issue, even if my interpretation of it is a contradiction to mainstream definition.

 

[DeepState]

Today's nugget:

"When learning begins we are unconscious of our incompetence and proceed to a stage were we are conscious of our incompetence; then when training begins we move to conscious competence; and as we master our new skill we arrive at the end point of our training - unconscious competence. Thinking, one could say, is something we only do when we are no good at an activity."

- Referring to studies of players of Tetris gaining expertise with practice and general observation in a range of fields.

---

"Remember this rule," advises Kahneman: "Intuition cannot be trusted in the absence of stable regularities in the environment".

---

So...is investment an activity which truly does lend itself to instinct and gut feel for most important decisions, even after prolonged practice and much experience? I have my doubts.

---



- Charlie Munger seems to think gut use without effortful and explicit consideration along several disciplines, which are carefully and deliberately synthesized, is not a good idea. Investment, to Munger, remains a meaningfully conscious and effortful endeavor.

I think he's on the money. The money, at least, is on him.

 

[qldfrog]

I like th notion of "using these tools checklist style";
indeed how often have i press on the buy button after considering; a trend, a curve or even a P/E but so rarely do I go thru all the checks that i am able to perform.
So for any reason, probably to enforce a gutfeel, a specific factor enable me to lie to myself and "justify" a buy/sell ..only to be proven wrong a few days at most later; yet I could have see it all coming just using some of the "other" criteria.
Self discipline is hard and the random aspect of the share market allow to have some random wins that one's ego see as confirming your delusion.
I am a quite logical cartesian, maths oriented person, yet ften, it is the unlogical side of me winning in trading.
And the poorer I end up, literally speaking
I need to create a checklist, strictly speaking to funnel my enthousiasm and force the logic in me.
Does anyone usean actual criteria checklist beforesell/buy (whatever your own criteria are, this is not the issue)

a year or so ago, I worked with amibroker and aimed that way:
i was buying /selling blindly based on my algorithm output...
did not ended up well, even if my backrun supposely gave me an edge..it did not after a year
anyway my 2c worth of experience

 

[galumay]

The 'toolbox' idea certainly resonates with me. My toolbox is my excel workbook that contains sheets for a watchlist of comapnies that come into my radar as possible investment opportunities, a sheet where I then document all the metrics of potential investments from the watchlist and also all the metrics of companies i have already invested in (before my 'check list' was fully developed.).

I try to keep it dynamic, so I will hide rows where I decide the calculation doesnt help with the decison making process and add metrics when I read about them - even if i am not convinced of their value I will at least give them a try.

All of this takes time - which puts distance between the emotional impulse to buy and the actual decision to do so!

I also have sheets that display graphically some of the data - like historical FCF and EPS - as I find some things are easier to understand with an image.

Another sheet has my DCF IV calculation formula, this allows me to model various growth patterns and required rates of return.

I also have set up a process for importing current prices of shares I am invested in and interested enough in to have run a full analysis, this gives me a 'live' picture of my analysis.

One thing I would note is that having developed this structured and process driven assessment of opportunities to invest, I am realising I need to make sure the same rigour is applied to the consideration of selling decisions!

I also think the trick is not to let the diverse 'toolkit' just turn into a bigger hammer! I try to remain aware of the truism that 'i dont know, what i dont know', and look for new 'tools' and angles of view.

 

[qldfrog]

and after rereading my email, apologies for the below standard spelling I have used.let's blame it on the rush i was in.
But the meaning is there; a toolbox of analysis tool/'formula", etc and a checklist ensuring you go thru your own self imposed tests before committing;
And yes galumay, a selling strategy is indeed as important as a buy one..
the risk management is also a given so not forgotten in term of position size, sector diversification etc..

 

[DeepState]

Checklists:

They are extensively used in flying (pre-flight checks etc.)
They have been substantially introduced into medicine (see 'Checklist Manifesto' by Atul Gawande)

Interestingly, to me, the above fields have a lot of stability in them. The things you observe have a reasonable chance of giving you an accurate read on what is going on. The actions from there are capable of being honed quite well. As a result, a checklist approach in these areas is less likely to lead to an improvement in raw outcome - if you are well experienced - relative to something like investments where situational awareness, cause and effect are much more tenuous. Flying and medicine are more like physics whereas investment is more like economics.

Possibly, the life and death nature of flying and surgery leads to a greater emphasis being placed on smaller gains and avoidable errors. Feedback loops are also much tighter and hence learning can progress more directly.

Still, I think that it is entirely valid to borrow from these ideas for the field of investment. I think the concept of some guru investor positioning largely on mythical gut impulses to rake in huge money is pure fantasy - and a dangerous one to try and emulate.

 

[Klogg]

And yes galumay, a selling strategy is indeed as important as a buy one..

@galumay, what is your selling strategy? I was initially of the opinion of finding a quality company and keeping it, but my investment has branched out into 'average companies at a bargain price', so I have changed this completely. I'm now of the same opinion as Baupost/Seth Klarman:
(see his audio recording here: http://www.bengrahaminvesting.ca/Resources/audio.htm).
"Feeding the birdies" is an approach I'm a lot more comfortable with.

Still, I think that it is entirely valid to borrow from these ideas for the field of investment. I think the concept of some guru investor positioning largely on mythical gut impulses to rake in huge money is pure fantasy - and a dangerous one to try and emulate.

Not that I'm anywhere near a model investor, but I've recently introduced a checklist that I review after I feel like I've finished my research. It's a good 80 questions long, and covers everything from risk, macroeconomics, industry, cash flows and management quality and incentives. And finally, at the end of it all in big bold letters is the question:
"Am I ignoring things on the checklist because I feel too complacent or attached to my research?"
along with a list of failed investments I've made previously (and dollar amounts).

@DeepState, do you use a checklist in your investment activities?

 

[galumay]

@galumay, what is your selling strategy?

I am still defining it in reality. Like you I favoured the buy and hold approach in general, by conincidence I recently downloaded Klarman's "Margin of Safety" and it certainly got me thinking more about the idea that if I am using my FA to select an entry point, the same analysis should indicate an exit point!

I am still mulling over that, I want to be careful to avoid trying to time the market which i think is a default risk of a selling strategy based around value. The other strategy is selling something in order to enter a better opportunity - I am in that situation at the moment with my SMSF, I have something I believe is a very good opportunity to take a position in, and I am considering selling another position which appears near IV and I may have over read its opportunity for growth.

Like DeepState points out, checksheets work best in very predictable and repeatable fields, I think they do add value in investing for 2 reasons, as mentioned it reduces the risk of brushing over a problematic area because of our emotional desire to be invested and it takes time which deters the impulsive decision making process!