Thought Bubbles from the Deep

[sinner]

Does this means pillar 2 above does not actually hold, the market can become unbalanced and passive investing can become "crowded" ?

Almost every form of investment strategy has the potential to become crowded. See overvalued markets/single names (if valuation was a constraint then markets/single names would never become overvalued). Also google the term "hedge fund hotel" or "quant meltdown 2007".

However worth noting again that most strategies are less crowded than commonly assumed, especially assumptions from the counterparty who believes the opposite strategy is foolish and crowded. Fundamental investors think momentum is crowded because anyone can implement. Momentum investors think fundies do nothing but catch all the falling knives. Active investors think passive is so crowded. And so on...

Given the ever increasing inflows into passive investing and the death of active management

I disagree that active management is dying (Pershing has an AUM of what? 18 billion? Just 1 fund. Berkshire is running >300 billion market cap...), and plenty of money "outflows" from passive investing every time there is a 5, 10, 20, 50% drawdown in passive indices as investors sell at inopportune moments.

Also Sinner, any other recommendations for other papers illustrating similar "truths" in the market ? Would love to get ahold of your reading list.

I like this http://www.hussmanfunds.com/wmc/wmc140414.htm but others seem to disagree/less enthusiastic. The only contention I have is that it assumes "constant dollars", i.e. no major change in real value of the unit of account.

My list is long, I have pasted plenty of links, feel free to go through my posts.

 

[DeepState]

ps sorry for hijacking your thread DS, started this post with only vague thoughts and it kinda grew from there.

More please.

 

[mcgrath111]

Hi Deepstate,

Really appreciate your insights! - While many of your concepts go over my head (The detail you go into is impressive!) really interesting to read none the less.

Some quick questions:

1) You've previously mentioned having an investing checklist (although you said you're not checklist orientated), I feel at my current stage I need some form of checklist to influence my decisions. I.e. Yesterday I bought SPO on literally a whim. While only a small amount I feel that I need something to making me accountable.

2) How do I go about designing an investing strategy? Everyone seems to throw ideas and opinions around, however I feel that you're one of the few people who are truly immersed in the industry.

Apologies if this is below your level of expertise and guidance; I just feel lost...While I'm looking at learning, perhaps at my current state, I'd be better of investing in an ETF?

Feel free to delete if this derails your thread.
(I'm currently a graduate accountant - who has a moderate understanding of finance).

Many Thanks,

 

[DeepState]

Question:

Jane Doe is 57 yrs on a disability pension (non-taxed income). Total asset position is $350k. $100k in Super from prior employer. Already being drawn down. $250k inheritance forthcoming. No other sources of income.

Given tax rates and prospective investment returns, my understanding is that she would be indifferent between housing the inheritance within a super environment or outside of it. Please confirm/deny.

Thanks.

 

[DeepState]

Hi Deepstate,

Really appreciate your insights! - While many of your concepts go over my head (The detail you go into is impressive!) really interesting to read none the less.

Some quick questions:

1) You've previously mentioned having an investing checklist (although you said you're not checklist orientated), I feel at my current stage I need some form of checklist to influence my decisions. I.e. Yesterday I bought SPO on literally a whim. While only a small amount I feel that I need something to making me accountable.

2) How do I go about designing an investing strategy? Everyone seems to throw ideas and opinions around, however I feel that you're one of the few people who are truly immersed in the industry.

Apologies if this is below your level of expertise and guidance; I just feel lost...While I'm looking at learning, perhaps at my current state, I'd be better of investing in an ETF?

Feel free to delete if this derails your thread.
(I'm currently a graduate accountant - who has a moderate understanding of finance).

Many Thanks,

Shall respond in pieces. I also need the answers to some of the questions you've posed.

Checklists:

Checklists are plentiful. If you want the super detailed micro-eco one, then "Security Analysis" by Graham and Dodd is the tome. It will take you through each and every micro item on the accounts and what you need to watch out for and how to normalise it. It's likely too detailed to be read as a whole and utilised in that way. It would be a useful reference for major items.

More practically, I think that the Porter Competitive Analysis framework (It was "five forces" when first released. Then people added value. I have no idea how many forces it has grown to now, but some recent finance or management grad can please jump in) is useful to help structure thinking about an industry. You can do pretty well by following that up with the Value Chain concept and see how various things connect. Buffett's biggest focus in business analysis. Understanding how a business works, what drives it and how much and how well it can guide its own destiny. Porter's stuff will help you with that. Porter is pretty much compulsory for industry and company analysis.

The following may be useful for more general checks on your own thinking: Farnham Street Latticework of Mental Models https://www.farnamstreetblog.com/mental-models/ basically a list of ways to think and list of ways we stuff up.

Underlying the checklist push is a book by Atul Gawande called "The Checklist Manifesto". If it's good enough for pilots and brain surgeons, it might be worth considering for investments too.

I think they are ways to make the best of what we've got.

 

[sinner]

I feel at my current stage I need some form of checklist to influence my decisions. I.e. Yesterday I bought SPO on literally a whim.

Item #1: Do not buy any names on impulse.
Item #2: Sell all names you bought on impulse.*

*not financial advice, only hypothetical checklist.

Shall respond in pieces. I also need the answers to some of the questions you've posed.

Checklists:

The book "Quantitative Value" has an entire chapter on checklists and the book ends in a comprehensive checklist. Worth a read .

Here is a free, simpler checklist from Aleph Blog (http://alephblog.com/) that I pulled into my notes long ago, it is valid IMHO.

How should you approach value investing from a purely quantitative standpoint? Easy:
Screen out stocks that have relatively high accruals
Avoid companies that may go bankrupt
Margin of safety: choose companies with strong balance sheets and profits
Look for long-term strength in profits.
Buy them cheap.
Buy when informed investors are buying.

Each of those lines can be broken out into its own topic of learning. Google:

* Accrual Anomaly
* Altman Z/Ohlson O/Falkenstein DefProb/Shumway bankruptcy
* Warren Buffet "moats", profitability anomaly, and other similar terms
* Understand the difference between geometric and arithmetic avgs
* Value investing
* Insider trading

However. Given your post, I would suggest as usual to save your money outside the market until you're significantly more well read. It'll still be here once you are.

 

[mcgrath111]

Greatly Appreciate the advice Deepstate & Sinner.

From when I was at uni a couple years back I think Porter was at 7 haha, although I never really thought of using it as a way of picking a potential stock shorlist / indicator to use.

Tonight I've had a glimpse into the references you've provided and it looks like I have a ton of reading ahead of me; but I'll need to put in the hours to one day be in similar shoes to yourselves.

I guess the biggest factor of not being actively invested is the matter of losing out, which I believe DS covered earlier. The market being down 17% ytd in my mind is ringing BUY,BUY,BUY! but in reality signals could be pointing the other way & I'm merely buying stocks off a low p/e alone.

Once again, many thanks for the advice, I think I'll start on Ben G's security analysis book and pose a question to you gents once in a while.

Cheers,

 

[fraa]

A thought of someone who is only slightly ahead of you on the road - its odd that you are displaying FOMO (fear of missing out) as FOMO is usually at market tops.

Maybe you are a contrarian at heart ?

Greatly Appreciate the advice Deepstate & Sinner.

From when I was at uni a couple years back I think Porter was at 7 haha, although I never really thought of using it as a way of picking a potential stock shorlist / indicator to use.

Tonight I've had a glimpse into the references you've provided and it looks like I have a ton of reading ahead of me; but I'll need to put in the hours to one day be in similar shoes to yourselves.

I guess the biggest factor of not being actively invested is the matter of losing out, which I believe DS covered earlier. The market being down 17% ytd in my mind is ringing BUY,BUY,BUY! but in reality signals could be pointing the other way & I'm merely buying stocks off a low p/e alone.

Once again, many thanks for the advice, I think I'll start on Ben G's security analysis book and pose a question to you gents once in a while.

Cheers,

 

[DeepState]

Hi Deepstate,

Yesterday I bought SPO on literally a whim. While only a small amount I feel that I need something to making me accountable.

Item #1: Do not buy any names on impulse.
Item #2: Sell all names you bought on impulse.*

I think that just jumping in with small assets that keep you interested but is not going to hurt you badly if it goes to zero is a reasonable, if superficially irresponsible, way to start. In theory, we should figure out what's going on before doing something. That's certainly useful for things where bad outcomes are really bad or fatal. In practice, for the most part, we don't do much until we have something at risk. So, a good way to begin is by watching what happens to SPO and trying to make sense of it as best you can.

Running SIM is nothing like running money. A backtest is sterile until you trade it and learn why you've just fooled yourself. Studying cases is fun, with all that retrospective stuff that seems so obvious in hindsight. In order to know how you will react when losing money...you have to actually lose money.

I think investment is a considerably experience based learning activity. If there is one thing I could suggest it would be to create some sort of loop where you:
1. make a guess/estimate of what you think will happen (direction, magnitude movement, relationship, volume, CB action etc...)
2. Observe what happens
3. Figure out why you're wrong...yet again
4. Try to improve your understanding.
5. Repeat ad infinitum

The people who do the above most effectively are the winners and grinners. It is so in many fields. Investment is made harder because the links between cause and effect are so tenuous and often unstable. It makes it hard to learn from feedback. One of the things to consider is that there is a considerable portion of stock price movements whose causes are best explained by "more buyers than sellers" or the reverse as the case may be.


+ I bought my first stock when I was around 10. Let's say there was not a lot of analysis to it when I bought Mount Isa Mines after it had a massive tear. Toasted a good portion of my savings, and that of my brother's (8 years) who bought on similar rationale, created from gifts and odd jobs in the form of forced labour. Both of us went on to have rather successful investment careers.

 

[artist]

Underlying the checklist push is a book by Atul Gawande called "The Checklist Manifesto". If it's good enough for pilots and brain surgeons, it might be worth considering for investments too.

Gawande does cover the relevance of the checklist to finance, investing and management on pp 162-173 of his book which you cited.

 

[sinner]

1. make a guess/estimate of what you think will happen (direction, magnitude movement, relationship, volume, CB action etc...)
2. Observe what happens
3. Figure out why you're wrong...yet again
4. Try to improve your understanding.
5. Repeat ad infinitum

Estimate that I re-watch this 10 minute Feynman snippet at least once a week.


(h/t John Hempton from Bronte Capital mentioning it re Epistemology on his blog)

 

[fraa]

Learning through a feedback cycle works for shorter term trading, but what happens when your time horizon is longer (e.g. Buffet style value investing - when your timeframe is "forever" ?).

i.e. I learn all I can, calculate IV for a business, then buy and hold its stock - when/how do I know I stuffed up the IV calculation or read the financials wrong ? If holding time frame is on the order of years to give the stock time to get to your IV, you dont get many cycles of learning/data to refine your own criteria/metrics.

That is the bigger I am having struggling with - I used to punt a bit with options and short term stock trades, but now I have a much more significant sum to invest for the longer term and I am struggling to figure out a process/framework to manage that. Routine DCA passive indexing is the obvious candidate here, but has no feedback learning cycle at all as you take the mkt avg - this will be my fallback but I wonder if there is something more.

Any advice appreciated as this seems to be something missing from the longer term value investing books like Dodd etc (unless I someone missed a chapter or something).

 

[sinner]

Learning through a feedback cycle works for shorter term trading, but what happens when your time horizon is longer (e.g. Buffet style value investing - when your timeframe is "forever" ?).

I wouldn't call Buffett style "value", but rather more simply "fundamental".

As craft likes to say, the feedback is provided by the annual reports of the companies you invest in. If the business is good in the next years report then continue, if not then not. You are not buying an holding forever, you are buying and holding as long as the annual reports are showing what you want to see.

i.e. I learn all I can, calculate IV for a business, then buy and hold its stock - when/how do I know I stuffed up the IV calculation or read the financials wrong ? If holding time frame is on the order of years to give the stock time to get to your IV, you dont get many cycles of learning/data to refine your own criteria/metrics.

This is a different, more quantitative style and the feedback must be enforced explicitly. Take (one of) the classic Graham value system (not proponent just example):

An earnings-to-price yield at least twice the AAA bond rate
Dividend yield of at least 2/3 the AAA bond yield
Total debt less than book value
Current ratio great than 2
Buy stuff that doesn't have a lot of debt--only buy stocks that have common equity / total assets over 50%
Sell if a stock moves 50%+
Sell if a stock has been in the portfolio for 2 years

 

[sinner]

The banks hedge their FX exposure. Their clients often do not. The banks will see this on their balance sheet as default. A devaluation will see rapid capital outflow initially which will require a monetary response to prevent outright asset and consumer deflation which will trigger a second round. Whether a monetary response to this will be successful is unknown. What I do know is that the CCP and Co could not control the stock market and have not been able to stop their capital account leaking by deca-billions each month. Much research suggests that credit events are preceded by rapid credit growth and asset price inflation. All of the pieces exist for the market to rightfully be concerned. If China falls, EM is next, and Europe comes after that.

Thx.

FWIW, I think Michael Pettis is the only China commentator worth listening to. On consideration of your reply and trying to think for myself I went and re-read his most recent blogpost which is still relatively fresh. There is too much wisdom for me to choose a decent snippet for pasting, I'll just leave a link and single sentence

http://blog.mpettis.com/2016/01/will-chinas-new-supply-side-reforms-help-china/

Contrary to some of the muttering out there, I don’t think Beijing is planning competitive devaluations in order to strengthen the tradable goods sector, in the hopes that surging exports will revive growth.

 

[fraa]

Thanks Sinner

Re: Pettis, also listen to the FT alphaville podcast here

http://ftalphaville.ft.com/2016/02/...-the-us-election-and-conservative-talk-radio/

Gives a brief summery to his views on common questions he gets asked about China.

Thx.

FWIW, I think Michael Pettis is the only China commentator worth listening to. On consideration of your reply and trying to think for myself I went and re-read his most recent blogpost which is still relatively fresh. There is too much wisdom for me to choose a decent snippet for pasting, I'll just leave a link and single sentence

http://blog.mpettis.com/2016/01/will-chinas-new-supply-side-reforms-help-china/

 

[DeepState]

Thx.

FWIW, I think Michael Pettis is the only China commentator worth listening to. On consideration of your reply and trying to think for myself I went and re-read his most recent blogpost which is still relatively fresh. There is too much wisdom for me to choose a decent snippet for pasting, I'll just leave a link and single sentence

http://blog.mpettis.com/2016/01/will-chinas-new-supply-side-reforms-help-china/

I'll add another couple from this excellent dude.

"China’s most serious problem is “the relentless accumulation of debt”, and economic conditions will continue to deteriorate until Beijing directly addresses the debt."

"I think the real reason for the recent RMB weakness lies elsewhere. Beijing is trying to boost
domestic liquidity in the hopes that this will generate stronger domestic demand, but
expanding liquidity fuels capital outflows, and these put downward pressure on the
currency, while increasing PBoC concerns about the monetary impact of money leaving the
economy which, as an article (https://next.ft.com/content/ae4dee44-bf34-11e5-9fdb-
87b8d15baec2) in last week’s FT argues, might be worse than we think."

This devaluation concern is not about trade based capital outflow. China is running a trade and Current Account surplus. It is the capital account which is causing the strain. There is strain because there is a heap of debt which has been applied to a heap of rubbish. As a result, foreign capital doesn't want to come in and local capital wants to get out. To fight it and keep the domestic economy afloat, reserves are being drained. In around 12 months, this will reach the bounds of IMF reserve recommendations for China's situation.

Despite de/revaluations against the USD, the Yuan has not shifted much at all on a trade weighted basis. This is not about trade. The Yuan will be devalued. The key questions are what that means for their debt market and credit mechanism.

---

Deutsche Bank now showing credit distress.
EU Peripheral debt blowing out.

 

[DeepState]

Learning through a feedback cycle works for shorter term trading, but what happens when your time horizon is longer (e.g. Buffet style value investing - when your timeframe is "forever" ?).

i.e. I learn all I can, calculate IV for a business, then buy and hold its stock - when/how do I know I stuffed up the IV calculation or read the financials wrong ? If holding time frame is on the order of years to give the stock time to get to your IV, you dont get many cycles of learning/data to refine your own criteria/metrics.

That is the bigger I am having struggling with - I used to punt a bit with options and short term stock trades, but now I have a much more significant sum to invest for the longer term and I am struggling to figure out a process/framework to manage that. Routine DCA passive indexing is the obvious candidate here, but has no feedback learning cycle at all as you take the mkt avg - this will be my fallback but I wonder if there is something more.

Any advice appreciated as this seems to be something missing from the longer term value investing books like Dodd etc (unless I someone missed a chapter or something).

Tough question.

If you are doing fundamental analysis, I suppose that you are trying to see if your expectations are being met at the fundamental level. Relationships between company outcomes and external developments can be tested. Ability to sustain profitability can be tested etc.

If you think that prices should follow fundamentals in a certain way, then this can be observed as well.

Although any individual holding might last for a decade and thus provide a weak feedback mechanism, you can also learn from stocks you do not hold. That gives you a vast set of potential data from which you can test your ideas and beliefs. These guys follow a stack more companies than they invest in.

Framework:

Step 1: Figure out your maximum loss tolerance. It will be a (real?) dollar amount over a time frame.
Step 2: Ask what you really really "know" about investment return forecasting. Halve it. And, maybe, again.
Step 3: Ask what instruments you have as investment opportunities that you are prepared to use.

Other steps to follow...

 

[CanOz]

DS, apparently the big trade has been short the EU banks, but aside from DB, the China syndrome and junk bonds related to oil in the US, do you think there are other shoes to drop?

 

[systematic]

This post really doesn't warrant its own thread as it's just a one off thought - not going anywhere with it...plus here seems appropriate as factor investing / smart beta etc is discussed in this thread etc.
DS - please let me know if this is not appropriate to your thread and a mod can perhaps delete or move to its own etc.

In the back of my mind I'd been meaning to take a look at this for a while now. The idea is simply, "what does the initial universe look like if you 'cut out the crap?'"

So...not looking for value, quality etc to help us find good stocks (which is what I do in my own investing). Simply looking to cut out the worst of the worst.

All I did was:
- start with a 500 stock universe (a basic market cap floor, a few clean ups, and then top 500 by liquidity)

- take a bunch of common stuff (basic value ratios, quality, momentum...nothing interesting...think price to book, price to earnings, accruals, Piotroski, 6 month price return, price volatility, ROIC etc etc...nothing unusual...maybe about 20 in all - roughly).

- My inclination would be to group the various measures by factor (i.e. a value factor, a quality factor etc), as that's how I role. But initially I didn't want to do that. I wanted to use all the measures individually.

- Delete just the worst decile (50 stocks, or thereabouts, depending on the measure) on all the measures. i.e. If a stock in the 500 stock universe was in the 'worst' 50 stocks under ANY individual measure of ANY particular factor...it's out.

We're simply coming up with a list where the individual stock isn't amongst the WORST as measured by any individual characteristic. It doesn't have to be 'good' on anything. And, we're using deciles (50 stocks) - we're not deleting as many as we would if we were cutting out the worst quartile etc. We're just cutting out the theoretical / hypothetical 'short' trades if we were doing that on each measure etc.

So - out of 500 stocks...how many do you think we're left with?

 

[sinner]

DS, apparently the big trade has been short the EU banks, but aside from DB, the China syndrome and junk bonds related to oil in the US, do you think there are other shoes to drop?

Here are some more shoes from William White who has a pretty hefty CV:

chairman of the Economic and Development Review Committee at the OECD in Paris. Prior to that, Dr. White held a number of senior positions with the Bank for International Settlements (“BIS”), including Head of the Monetary and Economic Department, where he had overall responsibility for the department's output of research, data and information services, and was a member of the Executive Committee which manages the BIS. He retired from the BIS on 30 June 2008.

http://www.zerohedge.com/news/2016-...s-oecd-chair-warns-our-entire-system-unstable

Three, everywhere you look it seems to me you can see a potential trigger. You look at China and it’s slowing, although nobody knows by how much because nobody believes the data. But things like railway transport and electricity use suggest China is slowing a lot. Unfortunately, if you look closely at the data, the conversion of the economy from investment to consumption is not really happening and the old growth model built on debt is coming to the end of its useful life. As well, you have problems in emerging markets and commodity producers – Brazil, Russia, oil regions – where associated fiscal difficulties could lead to greater social and political problems than might be expected in the advanced economies. In Japan, I think Abenomics is not working and will in fact backfire – raising prices when the typical salaryman hasn’t seen a salary increase in two decades equals a cut in real terms, meaning he will hunker down. For its part, Europe has a daunting list of problems – the Russian thing, the migration thing, the peripheral thing, the debt thing, and the absence of adequate political institutions to deal efficiently with all these problems. Even in the US people are talking about problematic student loans, low investment rates and the rising likelihood of recession.