Let's Talk "Zebras"

The only thing more comforting for an individual investor "missing" the March 2009 -Present rally is not having a professional career dependent on justifying why one "missed" the great returns in the market this year (my high-lights in bold). How difficult it is now for investors to pick great investments: when stock prices go up, risks goes up, not down.

Zebras!?
“Zebras have the same problem as institutional portfolio managers. First, both seek profits. For portfolio managers, above average performance; for zebras, fresh grass. Secondly, both dislike risk. Portfolio managers can get fired; zebras can get eaten by lions. Third, both move in herds. They look alike, think alike and stick close together.

If you are a zebra, and live in a herd, the key decision you have to make is where to stand in relation to the rest of the herd. When you think that conditions are safe, the outside of the herd is the best, for there the grass is fresh, while the middle see only grass which is half-eaten or trampled down. The aggressive zebras, on the outside of the herd, eat much better. On the other hand – or other hoof – there comes a time when lions approach. The outside zebras end up as lion lunch, and the skinny zebras in the middle of the pack may eat less well but they are
still alive.”

. . . Acorn Fund’s founder, and portfolio manager, Ralph Wanger

H/T Marketfolly. The full article by Jeffrey Saut is here.

Continuing on the topic of investment psychology, Ken Norquay describes risk management in a different way in his most recent entry. Here is an excerpt:

The investment industry’s pat answer does not address the basic truth that there is risk in investing in the stock market and we need to know how to handle that risk.

...


When I first entered the investment business in 1975, mutual funds guru John Templeton got it right. He used to say: “We shop the world for undervalued stocks. We hold them for three or four years and sell them when that value is recognized.” He wanted us to buy and hold Templeton Growth Fund in full knowledge that he would buy and sell stocks for us within the fund. Modern mutual funds do not talk about selling at all. They want us to buy and hold their mutual funds, and they want to buy and hold stocks within that fund. And they really do hold: how many mutual funds off loaded their stocks before the 2008 melt down? Mutual funds management has changed dramatically since 1975.

3 Things You Ought to Know

Michael Lewis is an author and financial journalist. In one of his bestselling books "Moneyball: The Art of Winning an Unfair Game," Lewis writes about how an underfunded team, the Oakland Athletics, was able to wins by 2002.

This book was published in 2003 and anyone - not just an ordinary investor - ought to read about how Billy Bean used statistics, challenged "conventional wisdom," and went against the MLB formula for running a baseball team.

I - Here are the highlights:

1. Know the end result you want

Before anything else, you should know exactly what you want. This requires thought. In Oakland A’s case, their goal was to win as many games as possible, not to retain their stars. This was because they found that the fans would come to games when the team was winning, regardless of whether or not they had their stars with them. They then aligned their strategies with this goal. They often couldn’t afford to retain their stars, but they could find ways to win more games.

2. Ask yourself: What is the Conventional Wisdom?

Now you should ask yourself what the conventional wisdom says about how to achieve your goal. List them. This is what most people think you should do to achieve your goal, and this is what the majority of people are doing.

3. Question the Conventional Wisdom

This is not easy, but this is how you can find opportunities. Your best weapon is why. By asking why you may find that:

• The conventional wisdom is unreasonable
  There is simply no evidence that it works. Most likely it became conventional wisdom because some people said so. In baseball for example, the way people count things can be traced back to a different game: cricket. Because the man who improved the box score in 1859 was familiar with cricket, he brought the ideas to baseball without thinking about whether or not that was the best way to count things in baseball.
• The conventional wisdom is not the best way to achieve the goal
  The conventional wisdom might contribute something to achieve the goal, but there could be other more significant factors that are overlooked by other people.

4. Find the real contributing Factors to Achieving Your Goal

The goal of questioning the conventional wisdom is to find the real contributing factors to achieving your goal. The more different they are from the conventional wisdom, the bigger the opportunities you have. To avoid guessing, it will be better if you can find data to support your ideas. If that’s not possible, at least make sure that you use clear logic.

5. Determine the kind of Stats you Need

After you find some ideas in step 4, think about the kind of stats you need to test your assumptions and help you do things correctly. For now, don’t think about how to get the stats; you will worry about that later. Just think about the ideal stats you need.

6. Find the measurement Tools

The next step is to find the tools you need to give the stats in step 5. Sometimes the tools are available, and sometimes they aren’t. If you can’t find the tools that exactly meet your needs, just find the best possible ones.

7. Measure what you Do

The next obvious step is to measure what you do when you apply your ideas. As I said in step 5, measurement is important to make sure that your assumptions are correct and you do things correctly.

8. Adjust Yyourself Accordingly

The measurement gives you the feedback you need to adjust your actions. This way you can do the right things better over time.

Comments and Application to Investing:

Money can only be made from the stock market using the"2x2" matrix. This idea was discussed on kaChing's blog. To recap, on one axis you are either right or wrong. On the other access you are either consensus (following the herd) or non-consensus (contrarian). As Andy Rachleff describes it:

What most people don’t realize is that you don’t make money if you are right and consensus because all the returns get arbitraged away. The only way to make money in the long term is to be in the right and non-consensus quadrant.

The 2x2 matrix is the model for investors to use for financial success. The reason is that time will be better spent ignoring the direction of the market and focusing the energy challenging consensus and being right (about a company).

II - More Philosophy

While I detest hearing the philosophy from others (it is meaningless without context), I detest even more in regurgitating it. With that in mind, here are other ideas that are worth repeating from Moneyball:

1. Every form of strength covers one weakness and creates another, and therefore every form of strength is also a form of weakness and every weakness a strength.

2. The balance of strategies always favors the team which is behind

3. Psychology tends to pull the winners down and push the losers upwards

III - The Kool-Aid Market

David Rosenberg summed up the advance in the U.S. markets by suggesting various pundits are drinking Kool-Aid:

Marc Faber is the latest pundit to drink the Kool-Aid and recommend stocks over bonds, citing the Fed’s printing press — the problem here of course, is that the U.S. stock market has only recovered in devalued U.S. dollar terms. Look at the Dow or S&P 500 in gold terms, Canadian dollar terms or euro terms, and this wonderful rally basically disintegrates. It’s otherwise known as a rally based on “money illusion.”

Reflections from 1934 - 1 Year Anniversary

With 870 members now registered in the "Intelligent Investing" group on I created on kaChing, it is appropriate to compare a 1934 publication to events that have taken place currently.

In Security Analysis, written by Benjamin Graham, Graham wrote about the real estate mortgage-bond business between 1923 and 1929.

For owners of the first edition publication, this is on page 116. In regards to a bond offering, there was a statement of "appraised value" of the property:

"A typical building which cost $1,000,000, including liberal financing charges, would immediately be given and "appraised value" of $1,500,000. Hence a bond issue could be floated for almost the entire cost of the venture so that the builders or promoters retained the equity (i.e., the ownership) of the building, without a cent's investment, and in many cases with a goodly cash profit to boot. This whole scheme of real-estate financing was honeycombed with the most glaring weaknesses, and it is a sad commentary on the lack of principle, penetration, and ordinary common sense on the part of all parties concerned that it was permitted to reach such gigantic proportions before the inevitable collapse."

1 Year Anniversary
One year after Lehman Brother's collapsed, Financial Post published a great story about it, entitled "After the Fall." Link: http://www.financialpost.com/story.html?id=1987721

Caution
Rosenberg is the former Chief Economist of Merrill Lynch. Now back in Toronto with Gluskin Sheff & Associates Inc., Rosenberg stated the following in his recent (September 11) newsletter:

One thing we do see is that the private client is taking the prudent approach towards risk. There have been $50 billion in net new cash flowing into equity mutual funds over the past four months. It is hard to believe that these flows can really push a $10 trillion market higher by 50%. But we do see that $130 billion of retail fund flows have gone into hybrids and bond funds — income is the key in a deflationary backdrop.

The market sentiment is obvious: investors are hungry for any asset class that generates returns greater than 0% (the approximate rate of government treasury bills e.g. yield on 1 month - 1 year t-bill is 0.13%-0.36%). This hunger is often accompanied by an appetite for greater risk as seen by rising stock prices.

On George Soros - Taleb's Perspective

There are two ideas in Nassim Nicholas Taleb's Fooled by Randomness worth addressing. They are highly pertenant states of the mind that is necessary in navigating through the markets.

The first is on the idea of changing one's mind:

An old trading partner of Taleb's, a man named Jean-Manuel Rozan, once spent an entire afternoon arguing about the stock market with Soros. Soros was vehemently bearish, and he had an elaborate theory to explain why, which turned out to be entirely wrong. The stock market boomed. Two years later, Rozan ran into Soros at a tennis tournament. "Do you remember our conversation?" Rozan asked. "I recall it very well," Soros replied. "I changed my mind, and made an absolute fortune."

Speculating how or why Soros could change is mind would be a fruitless exercise. Taleb's interpretation was that George Soros knew how to handle randomness by keeping a critical open mind and changing his opinions with minimal shame. (Which carries the side effect of making him treat people like napkins.)

The second ideas is on the idea of knowing...nothing:

My lesson from Soros is to start every meeting at my boutique by convincing everyone that we are a bunch of idiots who know nothing and are mistake-prone, but happen to be endowed with the rare privilege of knowing it.

When managing money, especially one's own, the first rule above everything else is, as Warren Buffett said it best:

"Rule No.1: Never lose money. Rule No.2: Never forget rule No.1"

Soros, for whatever reason, knew when to change his mind, but he did not do so on a whim or a guess (as it sounded in the book). There was detailed work done when an investment strategy was developed. However, when an strategy and investment thesis is carried out but is not working, even more work is needed to make up for losses.

The second idea is about being in a state that frees our mind from trying to control or model the unknown. Not everything may be forecast or predicted, and that which is unexpected to take place can take place. Knowing this (without actually knowing the unexpected) is something investors need to account in the analysis of stocks and the stock market.

Questions that Need Answering:

Here are a few things happening in the market that need resolution:

1. The U.S. 30-year Treasury prices are rising (yields are falling), and yet the stock market is rising. Is U.S. debt not the "safest haven" for investing? How are the debt auctions doing well if China is said to be buying metals instead of U.S. debt?

2. The S&P 500 rally since March was on declining volume, was without conviction, and sentiment was that of complacency (as indicated by the volatility index). Is there a risk of big players stepping in (or out) of the market in the next few weeks?

3. Will there be more government stimulus packages? Once the current programs run out, will markets ask for more?

4. If insiders are heading to the exits (insider selling is 95:1) why would ordinary investors be buying?



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