Montier on Exposures & Bubbles

Below are some wonderful bits on bubbles and portfolio construction from James Montier. Excerpts were extracted from a Feb 2014 interview with Montier by Robert Huebscher of Advisor Perspectives – a worthwhile read. Cash, Expected Returns, Exposure

“The issue is…everything is expensive right now. How do you build a portfolio that recognizes the fact that cash is generating negative returns…you have to recognize that this is the purgatory of low returns. This is the environment within which we operate. As much as we wish it could be different, the reality is it isn’t, so you have to build a portfolio up that tries to make sense. That means owning some equities where you think you’re getting at least some degree of reasonable compensation for owning them, and then basically trying to create a perfect dry-powder asset.

The perfect dry-powder asset would have three characteristics: it would give you liquidity, protect you against inflation and it might generate a little bit of return.

Right now, of course, there is nothing that generates all three of those characteristics. So you have to try and build one in a synthetic fashion, which means holding some cash for its liquidity benefits. It means owning something like TIPS, which are priced considerably more attractively than cash, to generate inflation protection. Then, you must think about the areas to add a little bit of value to generate an above-cash return: selected forms of credit or possibly equity-spread trades, but nothing too risky.”

Dry powder is generally associated with cash. But as Montier describes here, it is possible that in certain scenarios cash is not the optimal dry-powder asset.

His description of creating a perfect dry-powder asset is akin to creating synthetic exposures, something usually reserved for large hedge funds / institutions and their counterparties.

Interestingly, anyone can (try to) create synthetic exposures by isolating characteristics of certain assets / securities to build a desired combination that behaves a certain way in XYZ environment, or if ABC happens.

For more on isolating and creating exposures, see our previous article on this topic. 

Hedging, Fat Tail

“Bubble hunting can be overrated…I’m not sure it’s particularly helpful, in many regards…

Let’s take an equity‐market bubble, like the technology‐media‐telecom (TMT) bubble. Everyone now agrees I think, except maybe two academics, that TMT was actually a bubble. To some extent it didn’t really matter, because you had a valuation that was so extraordinarily high. You didn’t actually have to believe it was a bubble. You just knew you were going to get incredibly low returns from the fact that you were just massively overpaying for those assets.

Knowing it was a bubble as such helped reassure those of us who were arguing that it was a bubble, though we could see the more common signs of mania like massive issuance, IPOs and shifting valuation metrics that eventually were off the income statement altogether.

All of those things are good confirming evidence, but ultimately it didn’t matter because the valuation alone was enough to persuade you to think, ‘Hey, I’m just not going to get any returns in these assets even if it isn’t a bubble.’

Bubblehunting is much more useful when it is with respect to things like credit conditions and the kind of environments we saw in 2007, when it was far less obvious from valuation alone. Valuation was extended, but wasn’t anywhere near the kinds of levels that we saw in 2000. It was extended, but not cripplingly so by 2000 standards. But the ability to actually think about the credit bubble or the potential for a bubble in fundamentals or financial earnings is very useful.

The use of bubble methodology is certainly not to be underestimated, but people can get a little too hung up on it and start to see bubbles everywhere. You hear things about bond bubbles. Do I really care? All I need to know is bonds are going to give me a low return from here. Ultimately, for a buy-and-hold investor, the redemption yield minus expected inflation gives me my total return for bonds. There can’t be anything else in there.

You get the conclusion that, ‘Hey, I don’t really care if it’s a bubble or not.’ I suspect bubble hunting can be useful in some regards. But people use the term too loosely and it can lead to unhelpful assessments.”

Expected Return, Capital Preservation

“You can imagine two polar extreme outcomes: Central banks could end financial repression tomorrow. You would get real‐rate normalization and the only asset that survives unscathed is cash. Bonds suffer, equities suffer and pretty much everything else suffers. Or, the central banks keep their rates incredibly low for a very, very long period.

The portfolios you want to hold under those two different outcomes are extremely different. I have never yet met anyone with a crystal ball who can tell me which of these two outcomes is most likely – or even which one could actually happen. You’re left trying to build a portfolio that will survive both outcomes. It won’t do best under either one of the two outcomes or the most probable outcome, but it will survive. That really is the preeminent occupation of my mind at the moment.”

When To Buy, When To Sell, Psychology

“One of curses of value managers is we’re always too early both to buy and to sell. One of the ways that were trying to deal with that is to deliberately slow our behavior down, so we try to react at least to a moving average of the forecast rather than the spot forecasts.”

Wisdom From James Montier

I have a confession to make: I have a huge crush on James Montier. I think the feeling might be mutual (see picture below, from a signed copy of his book Value Investing: Tools and Techniques for Intelligent Investment.) Jokes aside, below are some fantastic bits from his recent essay titled “No Silver Bullets.”

Risk, Correlation

“…private equity looks very much like public equity plus leverage minus a shed load of costs…hedge funds as an ‘asset class’ look like they are doing little more than put selling! In fact, I’d even go as far as to say if you can’t work that out, you probably shouldn’t be investing; you are a danger to yourself and to others!

The trick to understanding risk factors is to realize they are nothing more than a transformation of assets. For instance, what is the ‘equity risk?’ It is defined as long equities/short cash. The ‘value’ risk factor is defined as long cheap stocks/short expensive stocks. Similarly, the ‘momentum’ risk factor is defined as long stocks that have gone up, and short stocks that have done badly. ‘Carry’ is simply long high interest rate currencies/short low rate currencies. Hopefully you have spotted the pattern here: they are all long/short combinations.”

Proper investing requires an understanding of the exact bet(s) that you are making, and correct anticipation of the inherent risks and correlated interactivity of your holdings. This means going beyond the usual asset class categorizations, and historical correlations. For example, is a public REIT investment real estate, equity, or interest rate exposure?

For further reading on this, check out this article by Andy Redleaf of Whitebox in which he discusses the importance of isolating bets so that one does not end up owning stupid things on accident. (Ironic fact: Redleaf and Montier have butted heads in the recent past on the future direction of corporate margins.)

Leverage

“…when dealing with risk factors you are implicitly letting leverage into your investment process (i.e., the long/short nature of the risk factor). This is one of the dangers of modern portfolio theory – in the classic unconstrained mean variance optimisation, leverage is seen as costless (both in implementation and in its impact upon investors)…

…leverage is far from costless from an investor’s point of view. Leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one by transforming the temporary impairment of capital (price volatility) into the permanent impairment of capital by forcing you to sell at just the wrong time. Effectively, the most dangerous feature of leverage is that it introduces path dependency into your portfolio.

Ben Graham used to talk about two different approaches to investing: the way of pricing and the way of timing. ‘By pricing we mean the endeavour to buy stocks when they are quoted below their fair value and to sell them when they rise above such value… By timing we mean the endeavour to anticipate the action of the stock market…to sell…when the course is downward.’

Of course, when following a long-only approach with a long time horizon you have to worry only about the way of pricing. That is to say, if you buy a cheap asset and it gets cheaper, assuming you have spare capital you can always buy more, and if you don’t have more capital you can simply hold the asset. However, when you start using leverage you have to worry about the way of pricing and the way of timing. You are forced to say something about the path returns will take over time, i.e., can you survive a long/short portfolio that goes against you?”

Volatility, Leverage

“As usual, Keynes was right when he noted ‘An investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money.’”

Expected Return, Intrinsic Value

“...the golden rule of investing holds: ‘no asset (or strategy) is so good that it can it be purchased irrespective of the price paid.’”

“Proponents of risk parity often say one of the benefits of their approach is to be indifferent to expected returns, as if this was something to be proud of…From our perspective, nothing could be more irresponsible for an investor to say he knows nothing about expected returns. This is akin to meeting a neurosurgeon who confesses he knows nothing about the way the brain works. Actually, I’m wrong. There is something more irresponsible than not paying attention to expected returns, and that is not paying attention to expected returns and using leverage!”

Hedging, Expected Return

“…whenever you consider insurance I’ve argued you need to ask yourself the five questions below:

1. What risk are you trying to hedge?
2. Why are you hedging?
3. How will you hedge?
• Which instruments will work?
• How much will it cost?
4. From whom will you hedge?
5. How much will you hedge?”

“This is a point I have made before with respect to insurance – it is as much a value proposition as anything else you do in investment. You want insurance when it is cheap, and you don’t want it when it is expensive.”

Trackrecord, Compounding

“…one of the myths perpetuated by our industry is that there are lots of ways to generate good long-run real returns, but we believe there is really only one: buying cheap assets.”

Montier & Mauboussin: Process Over Outcome

James Montier’s Value Investing: Tools and Techniques for Intelligent Investment is a book I often recommend to others - Montier does a wonderful job of pulling together a range of topics related value investing. Below are excerpts from Chapter 16 titled “Process not Outcomes: Gambling, Sport and Investment.” Montier derived much of the content below (story & matrix) from Michael Mauboussin's book More Than You Know - Chapter 1. Process Over Outcome, Mistakes, Psychology, Luck

“We have no control over outcomes, but we can control the process. Of course, outcomes matter, but by focusing our attention on process we maximize our chances of good outcomes.”

“Psychologists have long documented a tendency known as outcome bias. That is the habit of judging a decision differently depending upon its outcome.”

“Paul DePodesta of the San Diego Padres and Moneyball fame relates the following story on playing blackjack:

'On one particular hand the player was dealt 17 with his first two cards. The dealer was set to deal the next set of cards and passed right over the player until he stopped her, saying: ‘Dealer, I want to hit!’ She paused, almost feeling sorry for him, and said, ‘Sir, are you sure?’ He said yes, and the dealer dealt the card. Sure enough, it was a four.

The place went crazy, high fives all around, everybody hootin’ and hollerin’, and you know what the dealer said? The dealer looked at the player, and with total sincerity, said: ‘Nice hit.’ I thought, ‘Nice hit? Maybe it was a nice hit for the casino, but it was a horrible hit for the player! The decision isn’t justified just because it worked…’

The fact of the matter is that all casino games have a winning process – the odds are stacked in the favour of the house. That doesn’t mean they win every single hand or every roll of the dice, but they do win more often than not. Don’t misunderstand me – the casino is absolutely concerned about outcomes. However, their approach to securing a good outcome is a laser like focus on process…

Here’s the rub: it’s incredibly difficult to look in the mirror after a victory, any victory, and admit that you were lucky. If you fail to make that admission, however, the bad process will continue and the good outcome that occurred once will elude you in the future. Quite frankly, this is one of the things that makes Billy Beane as good as he is. He’s quick to notice good luck embedded in a good outcome, and he refuses to pat himself on the back for it…'

To me the similarities with investment are blindingly obvious. We are an industry that is obsessed with outcomes over which we have no direct control. However, we can and do control the process by which we invest. This is what we should focus upon. The management of return is impossible, the management of risk is illusory, but process is the one thing that we can exert influence over.”

“Outcomes are highly unstable in our world because they involve an integral of time. Effectively, it is perfectly possible to be ‘right’ over a five-year view and ‘wrong’ on a six-month view, and vice versa...During periods of poor performance, the pressure always builds to change your process. However, a sound process can generate poor results, just as a bad process can generate good results.”

James Montier on Tail Risk Hedging

James Montier always provides a wonderful blend of value and behavioral principles, as well as humor in his written work. His books (I'm the proud owner of a signed copy of Value Investing) and articles are always worthwhile reads (and available for free on the GMO website once you create an account). Here is a tail risk hedging article Montier wrote in June 2011 (around the same time AQR published another piece on tail risk hedging – see our previous post on the AQR piece).

A year later, tail risk hedging remains popular. As Montier astutely points out, “The very popularity of the tail risk protection alone should spell caution for investors.” Nevertheless, he gives some practical advice on how to approach with caution, including:

1. “Define your term.” – what exactly are you trying to hedge?
2. Once defined, consider locating alternatives to “hedging” that could help achieve the same result. Montier gives a few examples of how to “hedge” the illiquidity/drawdown risk we experienced in 2008 without actually buying hedges.
3. If buying insurance is the best course of action, be sure to calculate the expected return vs. the cost of insurance. This may require forward looking predictions on how certain existing securities/assets in portfolio will do in a tail event.
4. Last but not least, the most difficult part: getting the timing right.

I will add the following remark skimmed from a previous PIMCO discussion. Be sure to consider your benchmark before indulging in tail risk hedging products. In certain instances, the annual premium of these insurance contracts may be greater than what you can afford. For example, in today’s environment, foundations aiming to achieve CPI + 500 via relatively senior fixed income securities may find it difficult to sacrifice a couple hundred basis points of performance to hedging premium.