What follows is the “Looking Ahead” portion of my monthly letter to investors at T11. I have created an email list that sends this report out at the beginning of each month to those interested. The full report contains commentary about the general markets and individual positions held in managed portfolios, as well as overall performance. To be added to the list email me at mail@T11Capital.com
With a profession such as investing, people see the “doing” as the buying and selling. It is difficult to come home from work, and answer your spouse’s question, “what did you do today?” with “well, I read a lot, and I talked a little.” If you’re not buying or selling, you may feel you aren’t doing anything.
We believe in diversification for risk reducing, but we don’t want to diversify ourselves into ignorance. If we can do three smart things a year and nothing dumb, we will be very successful. If we can do five, that’s a home run. – David Abrams, worked under Seth Klarman, now runs Abrams Capital Management
The business of investing has caused madness in some men who thought they were on the precipice of financial immortality, only to later find that the theories they placed their faith in had fatal flaws revealing the desolate terrain lying beneath the beautiful mirage.
It has brought incomparable joy to others who have achieved great success whether through sheer luck or unique skill. The ability to achieve consistent success in the business of investing automatically vaults the individual into a category of analytical genius whose words can be relied upon to navigate the often random waters of day to day or month to month market movements.
At its essence, what drives one individual down the path of madness and another individual down the path of genius are slight degrees of separation along the very same path. It is indeed a game of inches where the quality of decisions made means everything. It is also a game where quality will always trump quantity. It is, in fact, true that the more decisions one is forced to make in any speculative venture, the more their results will fall towards the mean and eventually far below it. Speculation, in any form, does not agree with attention deficit disorder as it applies to decision or indecision.
The counter-intuitive nature of speculation is perhaps the biggest stumbling block that an investor will consistently face during their career. Everything that one is taught to function in normal society leads to madness, sorrow and depression in finance.
If you were to see a large crowd running away from something on a crowded street, human intuition will tell you that you very likely don't want to proceed in that direction. In the markets, the best opportunities come when you spot a crowd running and immediately shift direction towards the area of danger. Strike one for human intuition as it applies towards the markets.
In any work environment, the more effort and time you put into an endeavor the more you expect the payoff to be once you are finished. After all, hard work equals success. Time and effort equals breaking through barriers, eventually leading to achievement. In the markets, hard work will often lead to 1) over-thinking simple situations 2) excessive decision making 3) too wide a variety of investment candidates that are difficult to weed through. The more simple, streamlined and repeatable an investor's process is, the more the chances for success. Hard work in the markets often comes in the form of doing absolutely nothing. Strike two for human intuition as it applies towards the markets.
There is a great degree of comfort that comes with having company in any situation. Whether it be when an individual is stuck in a dark cave, with very little light and slithery creatures hissing between the stones. Or whether it be in a meeting where your point is favored over others in the room by a majority of those attending. We gain comfort from having people around us that can empathize with our situation and agree with our views. Having a majority of the public in agreement with your views in the markets, while giving an investor the warm and fuzzies, is highly detrimental to long-term value creation. Consensus agreement has been an evident feature of every major financial calamity in the history of mankind, whether the real estate bubble that popped in 2008, the internet bubble that popped in 2000, or the tulip bubble that popped 1637. All of these events had investors singing Kumbaya in flip flops and shorts while patting each other on the back for a job well done right before the guillotine dropped. Strike three for human intuition as it applies towards the markets.
The realization by an investor that their biggest battle is with themselves on a day to day basis is an important step towards avoiding madness. This realization allows an investor to view situations that are perceived to be dangerous as opportunities. This realization also allows an individual to be perfectly still without feeling inadequate or lazy. Lastly, this realization allows an individual to separate themselves from group thinking, believing that it creates unsustainable trends in the markets.
All of these attributes, when gained, allow an investor to greatly simplify their methodology because a clear path exists towards its expression. And that path is one that avoids trouble. The ability for an individual to stay out of trouble, while a seemingly simple concept, is at the heart of every great long-term investment track record
Warren Buffett has famously said, “The #1 rule is don't lose money and the #2 rule is don't forget about rule #1.” In other words, stay out of trouble. The investor who manages to stay out of trouble the longest will eventually win.
This brings me to my next point. After all, the title of this section is “Looking Ahead”: The current market is one that I am enthusiastic about on one hand and skeptical about on another. I am enthusiastic on a long-term basis, especially with respect to our current positions. The exposure that we currently enjoy has a tremendous amount of upside potential in the coming years.
The major market averages continue to make all-time highs against a backdrop of consistent skepticism, especially from the general public who are only paying attention because the fate of their 401k plans and pensions is determined, for the most part, by Wall Street. The general public, however, is by no means enthusiastic about speculating in stocks at this point in time during the bull market.
In a recent poll, Gallup asked 1,000 U.S. investors how much the market went up in 2013. Only 7% of respondents believed the S&P rose over 30%, which it did. More amazingly, 21% of respondents believed that stocks stayed the same. And 9% of respondents polled believed that stocks actually decreased. Keep in mind, the performance for the S&P in 2013 was the fifth best since World War II. To assert then that the investment public has been effectively blinded by the plague of negative market forces that were prevalent from 2000-2009 is entirely correct.
If you are long-term bullish on the U.S. markets this type of news is the equivalent of Julie Andrews singing Do Re Mi into your ear on a grassy hill surrounded by purple lilacs. There remains a tremendous amount of global liquidity, in the form of retail funds, that will fuel future up-legs of this bull market. The up-legs that vault the markets into the realm of over-valuation that many believe we currently reside in.
Over the short-term, however, I remain cautious on the markets despite new highs in the major averages. Admittedly, I had the run we saw in August as a low probability event overall. It was surprising both in its intensity and persistence since the low on August 7th. Fortunately, despite my skeptical view of the markets in August, we managed to keep our relatively significant long exposure intact resulting in matching the S&P's performance for the month. During times like this I am certainly thankful for the mechanical system of asset allocation I have developed that kept us in the game this month despite my bearish macro views.
These bearish views that I continue to see as legitimate concerns are not born out of thin air due to random analysis that says the markets are simply due for a pullback because of various valuation measures, sentiment or “overbought” conditions. The concerns I have are based on the technical merits of not just the general market averages, but a majority of individual stocks, as well. It is a situation where the amount of risk that has to be taken in order to achieve even moderate amounts of reward is as excessive as any point in this bull market. Essentially, the market needs a “reset” in order to create a condition where the amount of risk being taken is minor relative to the reward being offered.
The question then becomes what to do? For the astute investor, the volume of decision making during such periods should decline substantially knowing that there can be little no edge to the decisions made. When you are basically flipping a coin with respect to the potential profitability of new positions, it becomes natural that results will revert to the most relevant benchmark and often times, below it.
This is not a path that I am comfortable in the least bit as an asset manager. Being forced into mediocre decisions or as I prefer to call it, decisions with a negative expected value (EV), is a quality that is oddly popular among traditional asset managers, who then justify the decisions by curve fitting fundamental valuation, growth or macro models around them. Performance chasing, in other words.
We are in the fortunate position of not having to chase performance relative to the major benchmarks year to date. In fact, year over year our performance in 2014 is far ahead of 2013's performance when we were up 16.74% by the end of August, with a 200 basis point outperformance of the S&P 500. In 2014, we are outperforming the S&P by 1500 basis points through August, which gives me the ability to leverage those gains into Q4 should promising situations develop. A shoot the lights out approach when given the proper cushion, as we have now.
For the time being, I have no problem being extremely selective. Not in terms of new positions or allocations, but with the decisions I choose to make, realizing that the markets are in a spot that will prove statistically inadequate towards providing the edge needed to make decisions with a positive expected value.
Regards,
Ali Meshkati
