|Cheese consumption vs. death by bedsheet
|"Investing is always about making decisions while under a cloud of uncertainty. It is how one deals with the uncertainty that distinguishes the long-term value-based investors from the rest. Rather than acting as if the uncertainty doesn't exist (the current fad), the value investor embraces it and demands a margin of safety to reflect the unknown. There is no margin of safety in the pricing of U.S. stocks today. Voltaire observed, 'Doubt is not a pleasant condition, but certainty is absurd.' The U.S. stock market appears to be absurd."
|Hired to pound the table
|"Montier he has used the 35% sell off last month to urge purchases of cheap equities. He observes that 'Emerging markets were looking really, really cheap' and 'Europe was looking pretty damned exciting as well.' The reason for his enthusiasm was valuation: 'This was one of those examples where prices and fundamentals were getting dislocated.'"
|Late cycle lament
|"In order to believe that U.S. equities are going to generate a 'normal' return from these levels, you have to believe some quite extraordinary things. Perhaps you believe that P/Es are going to soar to levels not even seen at the height of the TMT bubble; or perhaps you believe that profitability is going to rise (from already extended levels) so that every firm in the U.S. looks like a FAANG stock; or perhaps you believe that growth is simply going to reach unprecedented levels."
|The world's dumbest idea
|"When it comes to bad ideas, finance certainly offers up an embarrassment of riches - CAPM, Efficient Market Hypothesis, Beta, VaR, portfolio insurance, tail risk hedging, smart beta, leverage, structured finance products, benchmarks, hedge funds, risk premia, and risk parity to name but a few. Whilst I have expressed my ire at these concepts and poured scorn upon many of these ideas over the years, they aren't the topic of this paper. Rather in this essay I want to explore the problems that surround the concept of shareholder value and its maximization."
|Shareholder value maximization
|"James Montier talks about shareholder value maximization (SVM) and its 'unintended' consequences."
|Equity markets are overvalued
|"James Montier, member of the asset allocation team at Boston-based GMO, has a hard time finding attractively valued assets these days. His advice to investors: Cash - and lots of patience."
|A CAPE Crusader
|"Having spent a large proportion of my career prior to joining GMO working at investment banks, I'm well aware of what Andrew Smithers describes as 'Stock Broker Economics,' the second tenet of which is 'The market is always cheap.' Over the years I've witnessed many attempts by the practitioners of this most dark art to justify why tried and tested measures of valuation are no longer meaningful, or occasionally create new measures of valuation that purport to show the market to be cheap."
|Hyperinflations, hysteria, and false memories
|"To say that the printing of money by central banks to finance government deficits creates hyperinflations is far too simplistic (bordering on the simple-minded). Hyperinflation is not purely a monetary phenomenon. To claim that is to miss the root causes that underlie these extraordinary periods. It takes something much worse than simply printing money. To create the situations that give rise to hyperinflations, history teaches us that a massive supply shock, often coupled with external debts denominated in a foreign currency, is required, and that social unrest and distributive conflict help to transmit the shock more broadly."
|Capital preservation and financial repression
|"Essentially, Bernanke's first commandment to investors goes something like this: Go forth and speculate. I don't care what you do as long as you do something irresponsible."
|The flaws of finance
|"The problems inherent in VaR are further amplified by the use of short runs of data to estimate the inputs. This creates an even more pro-cyclical element, adding to the problems of VaR. If the immediate past is a period of tranquillity, then the future is held to be the same. If a risky asset, let's say a CDO, happens to have been less volatile than U.S. treasuries over the last couple of years, the model says (with a straight face) that the CDO is less risky than treasuries!"
|The flaws of finance
|"James Montier discusses how bad models, bad behavior, bad incentives, and bad policies interact to create perfect storms for markets"
|What goes up must come down
|"Today I find myself once again digging through this toolkit, searching for a way to understand the development of profit margins. Currently, U.S. profit margins are at record highs according to the NIPA data. More freakish still is that these record high profit margins are coming during the weakest economic recovery in post-war history."
|The joy of cash
|"Long ago, Keynes argued that the "central principle of investment is to go contrary to general opinion, on the grounds that, if everyone is agreed about its merits, the investment is inevitably too dear and therefore unattractive." This powerful statement of the need for contrarianism is frequently ignored, with disturbing alacrity, by many investors. The latest example in the long line of such behavior may well be the general enthusiasm for so-called tail risk protection. The range of tail risk protection products seems to be exploding. Investment banks are offering "solutions" (investment bank speak for high-fee products) to investors and fund management companies are launching "black swan" funds. There can be little doubt that tail risk protection is certainly an investment topic du jour."
|"It is possible to build a speculative case for bond investment (i.e. riding the deflationary news flow down), however, as ever this leaves participants with the conundrum of Cinderella's ball as described by Warren Buffett 'The giddy participants all plan to leave just seconds before midnight. There is a problem though: They are dancing in a room in which the clocks have no hands!' Personally I prefer to stick to investment rather than speculation."
|A man from a different time
|"Looking at the U.S. market since 1871, on a 1-year time horizon, nearly 80% of the return has been generated by fluctuations in valuation. However, as the time horizon is extended, 'fundamentals' play an increasing role in return generation. For example, at a 5-year time horizon, dividend yield and dividend growth account for almost 80% of the return."
|Barbie does economics
|"Economics starts from a far worse place. It isn't a science, and often seems more interested in twisting the facts to fit a theory rather than the other way around. In fact, as Nassim Taleb has pointed out, economics is more akin to medieval medicine than its current practice, 'Medicine used to kill more patients than it saved - just as financial economics endangers the system by creating, not reducing, risk.'"
|Montier resource page
|"The essence of investment was to seek out value; to buy what was cheap with a margin of safety. Investors could move up and down the capital structure (from bonds to equities) as they saw fit. If nothing fit the criteria for investing, then cash was the default option. But that changed with the rise of modern portfolio theory and, not coincidentally, the rise of 'professional investment managers' and consultants."
|"I argue that policy portfolios and various successors (such as risk parity and life-cycle/glide-path funds) are deeply fl awed from an investment perspective. In particular, two common failings they share are a mismeasurement of risk and an indifference to valuation. I conclude that a strategic asset allocation that alters the asset mix based upon the opportunity set offered by Mr. Market makes far more sense from an investment perspective. (In modern parlance, this translates as a benchmark-free, real return focus.)"
|The dangers of DCF
|"Theoretically, discounted cash flow (DCF) is the correct way of valuing an asset. However, as Yogi Berra noted, 'In theory there is no difference between theory and practice. In practice there is.' The implementation of a DCF is riddled with problems. First off, we can't forecast, which kind of puts the kibosh on the whole exercise. Even if we choose to ignore this inconvenient truth, problems with the discount rate still make a mockery of the whole idea of DCF. No wonder DCF has such a poor reputation. The good news is that several alternatives exist. We explore three that avoid forecasting altogether"
|James Montier interview
|"Process is the one aspect of investing that we can control. Yet all too often we focus on outcomes rather than process. Yet ironically, the best way of getting good outcomes is to follow a sound process. The research shows that holding people accountable for outcomes tends to lead to suboptimal performance, generally because they spend all their time worrying about the things they can't control. I'd advise a far better approach to assess people on the criteria of adherence to process."
|Was it all just a bad dream?
|"This is where we encounter a lot of the pseudoscience of finance, e.g., measures such as Value-At-Risk (VaR). The idea that if we can quantify risk we can control it is one of the great fallacies of modern finance. VaR tells us how much you can expect to lose with a given probability, i.e., the maximum daily loss with a 95% probability. Such risk management techniques are akin to buying a car with an airbag that is guaranteed to work unless you crash! Talk about the illusion of safety."
|Montier on Value Investing
|"I've been thoroughly enjoying James Montier's new book Value Investing: Tools and Techniques for Intelligent Investment. I heartily recommend it to value investors. "
|Edwards and Montier ride again
|"However, we are less convinced that AMH is a terribly useful concept. As we understand it, the AMH provides a halfway house where sometimes markets are irrational and sometimes they are rational. We would argue that the amount of time that markets are rational is near negligible."
|Efficient markets theory is dead
|"The efficient markets hypothesis, or EMH, is the financial equivalent of Monty Python's dead parrot. No matter how much you point out that it is dead, the believers simply state that it is just resting. In part this is testament to the high degree of inertia that academic theories enjoy. Once a theory has been accepted it seems to take forever to dislodge it."
|The dead parrot of finance
|"Montier's charge sheet is a lengthy one. He says EMH has left us with a long list of bad ideas that have influenced the investment industry. These include an obsession with benchmarking, the capital asset pricing model, risk management etc."
|White swans, revulsion, and value
|"Current market conditions, dire as they are, represent not a black swan but a predictable surprise. Unfortunately, behavioral impediments in human nature made most investors unwilling or unable to see this predictable surprise. But despite the uncertain state of today.s markets, the investment environment holds many opportunities for value investors who focus on the long term." [Only free for CFAs]
|Stocks that may cause 'permanent' loss
|"Societe Generale SA strategist James Montier identified 42 stocks around the world, including News Corp. and BAE Systems Plc, that may cause a 'permanent loss of capital' for investors as valuations fall, earnings trail estimates and the companies struggle to repay debt."
|Montier has 'never been more bullish"
|"Societe Generale SA strategist James Montier said he's never been so bullish after the financial crisis dragged down prices for stocks, corporate bonds and inflation-protected government debt."
|Montier: 'Analysts are rubbish'
|"Seemingly everyone, on both sides of the Atlantic, is now taking about recession. Even Mervyn King. So why, asks SocGen's James Montier in his latest issue of Mind Matters, is the investment research industry still predicting earnings growth of between 12 and 15 per cent? He's got a chart to illustrate that analysts are exceptionally good at one thing and one thing alone - telling you what has just happened."
|Remember, Cassandra was right
|"Some are trying to argue that the mess in the US economy/housing market/credit market is an example of Taleb's black swan. Nothing could be further from the truth. Black swan events are inherently unpredictable. However, the events unfolding now are sadly all too predictable. They are following the standard pattern for a debubbling process. Numerous psychological barriers prevent us from listening to Cassandra, but it may pay to remember that her predictions were all too accurate."
|The road to revulsion
|"Indeed, one of the lessons that should be learnt from the Japanese experience is that the banks were second round losers, a point made by Albert Edwards recently. They didn't really begin to underperform the rest of the market until the second Japanese recession of its debubbling process. They really started to suffer when their consumers (Japan Inc) started to struggle."
|Joining the dark side
|"So we have covered three potential sources of short ideas. What happens if we put them all together? The parameters I used to define my shorts were a price-to-sales > 1, an F score of 3 or less, and total asset growth in double digits. This proved to be a powerful combination. Between 1985 and 2007 a portfolio of such stocks rebalanced annually would have declined over 6% p.a. compared to a market that was rising at the rate of 13% p.a. in Europe"
|Asleep at the wheel
|"However, more importantly once earnings have peaked they often return to the low edge of the growth bands. This represents a 45%- 50% decline in earnings. This number holds for the US, Europe and the UK. So if you want to have a worse case scenario then a figure like this should be used."
|Want higher returns? Don't take Prozac
|"Take it from Montier, a well known bear, pessimism is not an easy road, even though it may be a straight one. "Nobody likes a bear," he said. "As a career move bearishness is not a great idea, in a bull market nobody listens and in a bear market nobody will pay you.""
|The dash to trash
|"The US market is not priced for even a shallow recession - let alone a deep one. Investors are piling on the risk by blindly believing that they can tell 'true' growth stocks from the young pretenders - however, history suggests that a monkey throwing darts would generally do a better job! Investors with an ability to hold cash should consider this option. Waiting for the 'fat pitch' may be one of the smartest ways of dealing with the current juncture. For those who have to be invested, discipline will be key. Sticking with a proven process and focusing on the long- term should bring (long-term) rewards. Tilting towards large cap, dividend paying stocks or large caps with the resource to transform cash piles into dividends are likely to be the safest place to hide."
|The sources of value
|"The results of this further decomposition are shown in the chart below again for the period 1963-2006. The picture reveals show huge differences between value and growth stocks. Value stocks see hardly any growth in book value - not hugely surprising, they don't tend to invest large sums, in general they are more interested in cost cutting than investment. However, their is a very strong tendancy for convergence in price to book terms - that is to say their valuation rebound - although the decomposition is silent on whether this is the result of a bounce back in profitability or not. The same can not be said of growth stocks. They see an enormous amount of growth in book value - as they engage in large cap ex and M&A. However, they convergence is negative, they witness declines in price to book as their profitability erodes and valuations return to 'normal' levels."
|The folly of forecasting
|"One of the papers that didn't make it into the Behavioural Investing book (but with hindsight perhaps should have been added in) was on the performance of economists in forecasting recession. In it I pointed that economists are simply hopeless when it comes to forecasting recessions (I could have stopped that sentance before the word recessions). Their track record is truly appalling. The chart below shows that in recent history (1980 onwards) the consensus of economists has not managed to forecast either of the recessions that have occurred."
|Index investing isn't passive
|"Just for the record, Bogleheads are die-hard devotees of index investing. Occassionally someone will mistake my criticisms of much of the active management industry for support of the Bogleheads' position. However, this isn't the case. In fact I reject pretty much all the foundations that index investing is built upon (see Chapter 35 of Behavioural Investing). The only exception is that the Bogleheads are quite right to point out the importance of minimising costs."
|Prophet among pinstripes
|"The speaker wore his usual uniform of a faded black Timberland sweatshirt and jeans; his London audience was all tailored suits and double-cuffed shirts. But as James Montier finished explaining why money shouldn't be equated with happiness, the equity and bond traders rose to their feet in applause. "I don't think they heard much beyond rule 3," Montier quipped afterward. Rule 3 of his 10 for achieving sustainable happiness is, "Have sex.""
|Meaty beaty big and bouncy
|"The very concept of small cap investing is pretty suspect. From an empirical skeptic's viewpoint, the evidence is not convincing. Since 1981, most of the evidence appears to be that the size effect has vanished. Disentangling the size and value effects suggests that a very large proportion of the size effect is in actual fact a value effect! Even if you still believe in small caps (and it would have to be a matter of blind faith given the evidence) now is certainly not the time to be investing in them. Small caps are trading at a premium to large caps in both the US and Europe. This implies a negative liquidity premium - investors are paying for the pleasure of holding illiquid, inherently cyclically exposed stocks. This doesn't sound like a sound investment proposition to me. In addition, the delivered growth of small caps (whilst in excess of large caps) is usually less than analysts were expecting. Buying an expensive asset with a high likelihood of earnings disappointment (even without the business cycle risk) would seem to expose investors to unnecessary valuation risk."
|"Several findings are apparent from examining the table. First (and of foremost importance to me) is that buying cheap stocks did indeed outperform. Simply buying an equal weighted basket (assuming equal distribution of stocks across portfolios) of the lowest 20% of PEs within the MSCI World index generated significant outperformance (9.7% p.a. on average). Such a strategy would have only resulted in absolute losses in only five out of the thirty years in our sample."
|Come out of the closet
|"Occasionally, the underperformance of fund managers vs. the index is trotted out as evidence of the efficiency of the market. However, this confuses the absence of evidence with evidence of the absence. A new study suggests that closet indexing accounts for nearly one third of the US mutual fund industry. Stock pickers account for less than 30% of the market, yet they have real investment skill."
|CAPM is CRAP
|"As an empirical skeptic my interest lies in whether CAPM works. The evidence from the offset has been pretty appalling. Study after study found that beta wasn't a good measure of risk. For instance the chart below is taken from Fama and French's 2004 review of CAPM. Each December from 1923 to 2003 they estimate a beta for every stock on the NYSE, AMEX and NASDAQ using 2-5 years of prior monthly returns. Ten portfolios are then formed based on beta, and the returns tracked over the next 12 months. The chart below plots the average return for each decile against its average beta. The straight line shows the predictions from the CAPM. The model's predictions are clearly violated. CAPM woefully under predicts the returns to low beta stocks, and massively overestimates the returns to high beta stocks. Over the long run there has been essentially no relationship between beta and return."
|Just a little patience
|"As is my want I am going to start from the value perspective. Is time arbitrage a profitable pursuit for value investors? Certainly a priori one would expect so. As Ben Graham said, "Undervaluations caused by neglect or prejudice may persist for an inconveniently long time". As I have written many times before, when a value position is established, one can never be sure which potential return pathway will be taken. Effectively, any value position falls into one of three categories: 1. those that enjoy a re-rating as the market more generally recognizes a mis-pricing has occurred (type I) 2. those that generate a higher return via dividend yield, but are not immediately re-rated (type II) 3. those that simply don't recover, the value traps. (type III) So patience really should be a virtue for value managers as long as we are dealing with a type I or type II value stock. The chart below confirms just how strongly this is true. It shows the cumulative returns to an incredibly simple value strategy (buying the lowest 20% of the MSCI Europe ranked by trailing PE). The chart provides very graphic evidence for the rewards to patience. The strategy tends to generate around 3% outperformance relative to the market in the first 12 months. But if you carry on holding for another year, this rises to 5.7% (a year two return of just over 2%). However, at three-year time horizons and beyond, the excess return pick-up is much sharper, running at the rate of 8-10% p.a. for years 3, 4, and 5! Also noteworthy, is that the value strategy appears to start working from day one. This surprised me as I expected to see a period of underperformance or non-performance, rather than an immediate return to the value approach."
|An ode to quant
|"So why not quant? The most likely answer is overconfidence. We all think that we know better than simple models. My own confession at the start of this note is a prime example of such hubris. The key to the quant model's performance is that it has a known error rate, whereas our error rates are unknown. The most common response to these findings is to argue that surely a fund manager should be able to use quant as an input, but still have the flexibility to override the model when appropriate. However, as mentioned above, the evidence suggests that quant models tend to act as a ceiling rather than a floor for our behaviour."
|The limits to learning
|"Everybody thinks they are experts at learning. After all, most of us have gone through years of university education and emerged on the other side with a piece of paper 'proving' our ability to assimilate information. However, I'm not concerned with book learning; I am far more interested in learning from our own errors and mistakes or, somewhat more accurately, why we often fail to learn from our own past failures."
|Seven sins of fund management
|"How can behavioural finance inform the investment process? We have taken a hypothetical 'typical' large fund management house and analysed their process. This collection of notes tries to explore some of the areas in which understanding psychology could radically alter the way they structure their businesses."