On a Macro Level...
The enemy of money – inflation – must be beaten. Inflation, in the broader economy, should be kept under control over the medium to long-term, if the Fed still has credibility. 3-4% might be a good assumption. Beating this number, handily, calls for investing your savings. And there is a range of options, which makes investing confusing and intimidating. Broadly, our options, in order of my preference are:
- Invest directly in a few businesses (via stocks or bonds) after patient, careful analysis that is not divorced from common sense. This is also known as “Intelligent Investing” – a term coined by Buffett’s guru, Benjamin Graham.
- Invest “Passively” in Index Funds or on your own or through Robo-Advisors. I like the low fees. And the snazzy apps. But that’s about it.
- Invest in (usually mismanaged) mutual funds through your 401(K) or IRA or some other well-intentioned but mismanaged vehicle.
- If you’re “sophisticated” (aka rich): Invest in hedge funds, many of whom think they are superhuman investors worthy of eating up 15-20% of your returns. I too was once enamored when I was younger; not so much anymore.
- Do nothing. I’ll repeat: inflation must be beaten.
I have strong reasons for my order of preference. Here’s why, in reverse order –
This is covered in Why Invest. The point is that inflation is a leak in our bucket that we can’t simply patch up. We’ve got to have a running tap of returns to keep the bucket full. So, we must invest. Intelligently, preferably.
Masters of the Universe: Hedge Funds and Private Equity
These masters of the universe are full of confidence and machismo. Some effortlessly cross the line into arrogance. If you’re rich enough to get access to these masters, and you love the "exclusive club" feeling, then you may not want to read on. If you’re regular folk like me, then you’ll be glad to know that you’re probably not missing out on any degree of brilliance.
Hedge Funds first: Their pitch is catchy: “higher returns AND lower risk” – think of a smooth upward sloping line (depicting the value of your money) far outpacing a very jagged S&P 500 line. Very few have achieved that type of picture. I doubt, highly, that as a group they’ve achieved higher returns OR lower risk. Many of them don’t actually “hedge” anything; if they do it’s often the wrong kind of risk. Their clients’ returns are usually clipped by obnoxious fees like 20% of any positive returns, even when the returns are paltry. That’s on top of a 2% management fee. Why so obnoxious? Because they’ve convinced people that they're brilliant and that they have some superhuman investing skills. Most of them don’t. There are exceptions but as a group, I think they’re better salesmen than investors. It’s hard to confirm any specific skill mot of them tout but it’s clear that they skillfully pass off two concepts of investing as, well, “skill”:
Shorting: The act of making money from falling stock prices by borrowing the stock from a “prime broker”, watching the stock price tumble, buying the stock later in the open market, and then returning the borrowed stock to the prime broker. This is not a complicated strategy. You can probably do it yourself with your online broker. It’s slightly more cumbersome, operationally, but it doesn’t justify obnoxious fees.
Leverage: this is the act of borrowing money, outside the amount of money they manage for clients. They do this to double down on their bets and magnify returns. The flip-side is that it also magnifies risk, regardless of how you measure it. They don’t tell you that in their sales presentations. Leverage is not a skill. Access to leverage doesn’t justify a 20% performance fee. Having said that, there are some "arbitrage" strategies that can't exist without leverage. They bet on small mispricings and spreads eventually converging until the arbitrage "disappears". These spreads are so small that an "arb" fund needs leverage to amplify returns to a level that beats inflation. For them leverage is part of the strategy.
Speaking of Leverage, Private Equity Managers are experts at it. They’re also self-proclaimed superhuman investors who have the audacity to charge 20% of positive returns. They claim to have the skill of finding and buying out entire “diamonds in the rough” companies (public or private) which they can polish with their Midas touch. They buy a few companies usually with a lot of money borrowed from the “high-yield bond” market. This type of transaction is known as a “Leveraged Buyout” or an LBO. I’ve analyzed hundreds of LBOs over the course of my career. Very rarely have I seen a genuine turnaround caused by specific managerial or operational actions of Private Equity Managers. Mostly, I’ve seen examples of extreme cost-cutting, which are often followed by waiting for the market conditions to be “right” (read as Irrational Exuberance) so they can “exit” the starving company by selling it at a “decent multiple”.These are mostly gimmicks. But, to be fair, a few private equity managers do have operational expertise. They employ people with actual industry experience, who actually have experience running the types of businesses they acquire. Also, anecdotal evidence suggests that Private Equity Funds, as a group, have generated higher returns than “the public markets” over the last three decades. But that comes at the cost of liquidity – clients’ money in Private Equity funds is usually tied up for years. But I’m inclined to argue that they deserve their fees more than hedge fund managers, on average. Either way, these funds are not accessible to most of you, or to me. But we do have access to Mutual Funds.
Neither hot nor cold: “Traditional” Asset Managers
These guys are the punching bags du jour. Picture a paunchy fund manager with a well-known Mutual Fund company, sitting in a fancy office with an ugly tie and an ill-fitting pin-stripe suit from the 1980s. Most of the criticism thrown at them, sartorial and otherwise, is probably justified (the sartorial bit is a joke). However, performance-wise, as a group, their record hasn’t deserved their high fees (usually more than 1% of your money, yearly). Most fund managers, we’re told, don’t beat their benchmark over the long run. So, they’re vilified by media and by academics. The thinking goes something like this: “If these fund managers don’t usually outperform their benchmarks (indexes) anyway, then I may as well just bet on “the market” for a fraction of the fee…” This is logical and sensible. However, the commonly believed reason for this underperformance is often misguided.
Proponents of Passive Investing get theoretical and philosophical with their arguments. They claim that markets are so “efficient” that no amount of analysis can produce superior investment results over the long term. There is some merit to this argument, but I think it’s too simplistic. It goes something like this: “the US stock market is quite efficient over the long run because its participants – many of these portly fund managers and research analysts – are generally intelligent people with fancy degrees and a deep knowledge of finance and accounting, all of which imply that prices of stocks at any given time are well thought-out. So, there is no meaningful upside.” But I think this misses the point. Market Efficiency, as it is normally defined by academics, is not the main reason why this group can’t outperform the market. The reasons have more to do with institutional imperatives, culture, market structures and incentives. Fund managers tend to be overdiversified within their portfolio, overactive with trading, and overanxious about the opinions of others. Those are some of the reasons the market is not efficient at every given moment in time. Collectively, I call it "leaking horsepower".
About the religion of Market Efficiency: I think that the market generally efficient, over the long term (a few years). Many rational investors - usually not these portly mutual fund managers – can find plenty of investing opportunities in the interim. The giants of investing certainly can. And two of them succinctly explain why most fund managers don't beat the market. Hint: It's not because market are efficient.
“All the equity investors in total, will surely bear a performance disadvantage per annum equal to the total croupiers’ costs they have jointly elected to bear. This is an inescapable fact of life. And it is also inescapable that exactly half of the investors will get a result below the median result after the croupier’s take, which may well be somewhere between unexciting and lousy.” – Charlie Munger
“Most managers,” Buffett has said, “have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious; if an unconventional decision works out well, they get a pat on the back, and if it works out poorly, they get a pink slip. Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.”
Munger’s point is, well, staggeringly obvious, but rarely acknowledged. And Buffett’s point highlights, yet again, that incentives drive behavior; not intellect or fancy degrees or fancy valuation models or even boxy pin-stripe suits.
Fashion du Jour: Passive Investing
This is the latest investment fad. I like the idea – low cost, worry free, systematic. But there are many things I don’t like about it:
- I’m not comfortable with the idea of treating financial securities as scientific concepts with certain immutable characteristics. They’re not scientific concepts – their prices are driven by fear and greed. Valuations don’t depend on history; they depend on the future. The concept of “historically high or low valuation” is useless. Unlike what we have in physics and chemistry, there are no immutable laws in economics and finance. There is a whole school of thought that will have us believe otherwise.
- In “passive” investing, I won’t have a choice on the companies to which my financial well-being will be tied. Many investors may not care. But I do. And maybe you do. If I go the “indexing” route, how my money is allocated will be probably determined by company size or some other passive rule set by an index administrator like S&P (who are not really investment experts themselves – that’s not their business).
- Investing in a “market-capitalization-weighted” index (many of them are weighted this way) is the equivalent of a “buy high, sell low” trading strategy. Let’s take the S&P 500. Stocks in the index are weighted by market capitalization, which by the way, is stock price multiplied by number of shares outstanding. In other words, it’s the market’s estimate of the company’s net worth. If the price of stock X increases, it’s market-cap increases, and it’s weighted more heavily in the index. Stock X now becomes a larger force in determining how the index moves. Compared to yesterday, you’ve now implicitly bet more on stock X’s fortunes just because it’s price went up today. Again, most investors may not care. But this bothers me.
- Passive investing isn’t really passive. It’s still an “active” strategy when it comes to “Asset Class” allocations – think stocks vs. bonds vs. commodities etc. Making strategic or tactical calls on these Asset Classes is a difficult exercise, in my opinion, even for so-called Asset Allocation specialists. Again, asset classes and their prices not scientific data-sets. My experience in the “quant” arena holds me back from having much faith in “asset allocation models”; especially if they’re based on the “Modern Portfolio Theory”.
- But these new Robo-Advisors claim to be adept at Asset Class Allocation. Their pitch goes something like this: “We’ve got a kick-ass Asset Allocation program behind the scenes based on theories like Modern Portfolio Theory (which has been debunked time and time again, but don’t worry about that) and we allocate in low cost index funds according to that program…” Again, I like the low-cost bit. And the snazzy apps. But the theoretical and philosophical dogmatism is astounding.
- “Beta and Modern Portfolio Theory and the like – none of it makes any sense to me…how can professors spread this? I’ve been waiting for this craziness to end for decades. It’s been dented and it’s still out there.” – Charlie Munger
- I won’t be investing with Robo-Advisors any time soon. But many will, and many should. If you want nothing to do with investing, but still want a sizable retirement nest-egg, robots are your best bet.
Timeless Style: Intelligent Investing
This is how The Buylyst rolls. This is synonymous with the Graham-Buffett-Munger style of investing. You can call it the Buffett way, or common-sense investing, or focus investing, or margin-of-safety investing, or something snappier than that. I’ve discussed Intelligent Investing in detail here. But here is The BuyGist:
- Intelligent Investing is less about IQ and more about character and the nervous system.
- “Ignore the chatter, minimize costs, invest as if you would in a farm” – Warren Buffett
- Read, observe, scuttlebutt, travel, read, think, debate, meditate, do your homework. Read some more.
- Invest in companies, not in stocks or bonds or derivatives. Stocks and Bonds may be avenues you use to invest in a company. “Be a business analyst, not a market, macroeconomic, or security analyst.” – Charlie Munger
- Invest in companies that at least have these 3 characteristics: 1) A “castle” – does their business really need to exist? 2) A wide “moat” – can they protect their competitive advantage? And 3) Top-Notch Management – are they keeping the castle nice and shiny? Are they widening the moat?
- Do your rough valuation. No need to spend weeks calculating a company’s value to the 10th decimal point. An estimate of Intrinsic Value of the company will do. That should be based on your data and analysis, not the market’s.
- Three Magic Words of Intelligent Investing: Margin of Safety. Don’t compromise on this. This is how you’ll manage your Risks.
- Trade infrequently. Because opportunities will be infrequent. If you adhere to a strict Margin of Safety rule, you won’t find many opportunities. But when you do, go big. “Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.” – Warren Buffett.
- Invest in a few companies to which you can give due attention. Don’t over-diversify. You don’t need to invest in more than 20 companies. Maybe you won’t even find 20. That’s OK.
- Don’t worry about gyrating markets, Wall Street opinions, volatility, or any other external appraisals of the business in which you’ve invested. This is the hardest part of Intelligent Investing – ignoring the chatter.
- Have the confidence to “zag” when the market is “zigging”. “You are neither right or wrong because the crowd disagrees with you. You are right because of your data and reasoning.” – Benjamin Graham
The Buylyst has borrowed heavily from the giants of investing. Over time I’ve realized that regardless of “asset-class” expertise or “style” or whatever box investment consultants and academics assign to these giants, they all adhere to the principles of Intelligent Investing. And that’s it – Intelligent Investing is principles-based. And it’s time-tested. And it jives with common sense. And my core values. The Buylyst is my interpretation of Intelligent Investing. This is how I think, analyze, and invest. And now, I hope to spread the love.
“The man who grasps principles can successfully handle his own methods. The man who tries methods, ignoring principles, is sure to have trouble.” – Ralph Waldo Emerson (allegedly).
Many Happy Returns.