What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital.
Blurred Lines
The line between trading and investing is an often debated element of successful methodology within a portfolio. There are some who consistently blur the line, which is perfectly acceptable as long as an investor realizes the “why” behind the action. It is only when a market participant cannot identify whether they are a trader or investor due to inconsistencies in their methodology that trouble follows.
I have often said that not enough investors embrace simple trading methods that can enhance their performance. Likewise, not enough traders embrace investment philosophies that can also enhance performance over the long-term.
Our unsuccessful investment in EMAN highlights the trading and investment hybrid philosophy that has been a key element in overall performance. That philosophy can be summed up as one of being an investor on the upside and being a trader on the downside.
It is true that far too many value investors take their investment thesis to heart, which damages overall performance through a stubborn resilience that is based on adhering to fundamental data points that are lagging indicators of earnings or corporate performance. This causes excessive volatility within a portfolio and absolutely atrocious performance during cyclical or secular bear markets.
Within a bear market scenario, as an example, your typical Ben Graham value investor will suffer drawdowns that are often times irrecoverable. Without a tangible exit or risk-control methodology the valuation proposition increases in attraction as price declines which leads to overexposure in an underperforming asset. This consequently will lead to two eventualities: 1) The investor must wait an inordinate amount of time to achieve profitability 2) The investor in the meanwhile suffers opportunity cost as capital achieves more substantial returns elsewhere.
This all occurs because of a value methodology that has no counterbalance other than the intellect of the individual operating the strategy. That intellect, of course, is severely biased and utterly incapable of separating itself from the tenets of the philosophy that are rooted in deceptive fundamental data points.
The only counterbalance that I know of to properly peel away often erroneous conclusions of the intellect from an individual is the study of price, which is rooted in trading. Thus, one must be a hybrid trader and investor. When the downside becomes excessive or misbehaves in certain predetermined forms, the trading methodology separates an individual from their intellect, essentially overriding all other considerations but price action.
Otherwise, individuals become prone to all matters of erroneous decision making based on data points that we are ill-equipped to decipher during stressful periods of time. A simple eject button based on trading philosophy could have saved many a career on Wall Street.
So with EMAN, the trading side took over after a couple months of underperformance in the asset. This doesn't mean that I am less in love with my fundamental thesis behind the investment in the first place. It just means that I peeled away an intellectual conclusions made with regard to the investment for the sake of risk, opportunity cost and sound portfolio management.
The Art Of Saying No
There is an aspect to investing that is rarely spoken of due, I presume, to the fact that it is a forgotten about contributor to overall success. The opportunities that an investor decides not to pursue are perhaps as responsible for gains above and beyond the relevant benchmark as any top performer during any given calendar year.
In my world of investment which encompasses market-caps from $500 million all the way down to $10 million, there are literally thousands of companies that are available for investment. On any given day, I will look at a handful of the thousands of names that I can allocate funds into. Almost invariably, I will say no to all of them.
It is rare that I say yes. Lately, in fact, attractive new investments (companies I have never profiled or invested in before) are coming up at a pace of one or two every three months or so. That means that I say no roughly 500 times per quarter. Whether I say no because an investment doesn't have the proper management, is overcrowded, possesses little in the way of a catalyst or has a gimmicky concept at the core of its revenue model, the reasons are as varied as the industries the companies are in.
Taking a machine gun approach to the markets dilutes an investor's focus, thus diluting returns. A concentrated approach that is discriminating in nature allows for a multitude of benefits:
- It allows an investor to focus on their best ideas. When you populate a portfolio with companies it is inevitable that you will run into net losers. The net losers inherently tend to occupy the attention of an investor to the detriment of those positions that can and will produce gains. Tending a flock is the job of a shepherd.
- It separates performance from both peers and benchmarks. The more an investor says no the more the names they say yes to are forced to carry the weight of performance.
- It creates an alignment in strategy. Those who tend to say yes to investment ideas often also say yes to investment methodologies. One week they are a value investor, next week they are a trend follower and the next month they are trading commodities using crop data and economic statistics.
- It keeps overhead to a minimum. Good business practices extend to how much you pay to operate your portfolio as much as it extends to how much you pay for material to manufacture in a factory or fuel to run your ship from one port to the next.
- It allows for clean psychological output. Confusion in a portfolio due to saying yes too much will confuse the mind. Conversely, a confused mind will reflect in a confused portfolio.
Although I don't discuss this aspect of portfolio management often, it is perhaps as responsible for overall returns as any of the winning positions we have had over the past several years.
The Macro
There are some very obvious situations occurring in the global economy that feed right into the liquidity driven ascent we have experienced since 2009.
First, the global economy is generating low to no inflation. Whether this is because of the uneven growth being experienced in the emerging markets or a global focus on technological innovation leading to price efficiencies, I am less concerned about the reasons than I am the overall influence this dynamic will have on global central bank behavior.
As an example, on July 10th Janet Yellen in a speech stated, “monetary policy will need to be highly supportive of economic activity for quite sometime.” In the same speech, she also stated that “it will be appropriate at some point later this year to take the first step to raise the federal funds rate.” The message here is that while they may hike rates one or two times in the near future, there is a tendency towards allowing the liquidity spigot to flow freely for sometime to come. Also worth noting is the fact that this speech was given before the Greece crisis intensified and prior to the Chinese market diving.
The highly supportive stance of central banks worldwide inevitably means that liquidity will find 1) the most stable areas of growth 2) areas where consistent growth is possible. The fact that central bankers in China and Europe are injecting liquidity in an effort to stave off a full scale crisis, while the U.S. economy has already averted their crisis years ago, well into the present stage of predictable growth, simply means that U.S. assets become all the more attractive in the eyes of global investors searching for a home to take care of their capital.
Emerging markets, such as the BRIC, are no longer a viable option as the crisis in the commodity markets has compromised their position as leaders in the new economy. We are in a developed market led economy as opposed to an emerging market led economy. That simple distinction has vast ramifications for how investors will allocate their assets.
The advantage of the U.S. economy is that its primary competitor in the developed market space – Europe – is having emerging market problems due to the relatively new partnership that is the European Union and the chronic mischief that smaller countries such as Greece are capable of causing within that fragile union. So while the EU is a developed economy in form, in actual practice it is functioning as an emerging economy due to the newness of the union.
This leaves only one viable option for global investors seeking absolute safety, trust and predictability for their assets: United States equities and debt. The ramifications of which are a persistent sustainability in prices and growth in equity prices that continues to baffle and confound the critics, while long-term rates remain relatively low.
While this may seem like an overly-simplistic approach to a rather complicated problem, it really comes down to one consistent fundamental fact that persists regardless of time or place: Assets inherently flow to where they can achieve the most sustainable pace of growth without threat of sudden shocks, mischief or impropriety of any sort. The only place in the world that can lay claim to that title with increasing certainty are the United States capital markets.
Regards,
Ali Meshkati
