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Monthly Archives: August 2014

Biomimicry and the Nature of Investing

26th August, 2014 · Tom Brakke, CFA · Leave a comment
Tom Brakke, CFA

Modern markets can seem to operate in a sphere of their own, divorced from the real economy and the real world. Plus, the process of investing has become more systematized and abstract over the last couple of decades – with the theory and jargon of the business often conveying a sense of false precision about the behavior of markets.

As a portfolio manager and former head of U.S. equity research at Fidelity, Katherine Collins felt those disconnections and yearned for a broader perspective. Her radical career shift – heading off to Harvard Divinity School – left her co-workers and others surprised. How could she leave the exciting business of investing?

As Collins told a recent meeting of CFA Society Minnesota, she never abandoned her love for investing. But she wanted to find a new context for her decision making, and her experience at divinity school, the Santa Fe Institute, and the Biomimicry Institute led her to use the lessons of nature to approach the challenges of investment analysis.

Her insights can be found in a new book, The Nature of Investing: Resilient Investment Strategies through Biomimicry, and she formed Honeybee Capital to produce research using her approach. (More information can be found in an interview with Collins in CFA Institute Magazine.)

Many of the precepts that Collins discussed involved cutting through the complexity of the investment conventions of today with simple concepts inspired by nature. She talked about the honeybees which gave her firm its name, pointing out how they cooperate to share information “openly and without spin.” When faced with a problem, they head out into the world to observe and then work together toward an optimal solution. Contrast that with many investment decision makers, laboring away alone in their offices, looking at the world through digital windows.

In fact, for people of a certain age, one of Collins’ examples was particularly apt. Back in the day when not everyone had a Quotron (the dominant electronic data platform then), they used shared terminals in common areas. That had at least two positive effects: co-workers rubbed shoulders more often and got to know each other better, strengthening the teamwork in the organization, and they shared information about their respective areas of expertise, resulting in a cross-pollination of ideas that yielded new insights. According to Collins, “the inefficiency of the Quotron was what made it so special.”

Yes, “we have become tools of our tools,” that derivation of a Thoreau quote being one of many that Collins used to show how the challenges we face aren’t exactly new (although with amped-up tools we probably have amped-up challenges). We feel like we have all of the answers at our fingertips, but only to certain questions, and probably not the key ones.

For Collins, the most important result of her inquiry into biomimicry is that it helps her to ask better questions about the investment process. She gave a number of examples of unusual adaptations among species that led her to see an investment dilemma in a new light.

The biggest issue that we confront is “risk” versus “uncertainty.” The former is bounded by the parameters of our experience, and the investment world has turned it into an apparent science. Risk equals standard deviation (although that’s a very unusual definition) and the language of risk in that sense has become universal, driving the investment framework for everyone from individuals to massive institutions. This “land of risk” is mapped and quantified – and our tools are honed to guide us within the normality that we think exists.

But the “sea of uncertainty” is something else again. It’s ironic that the financial crisis caused the risk culture to become even more entrenched; it should have exposed the shortcomings of that framework for dealing with unanticipated situations. Collins thinks that those who tread the land of risk (an overwhelming percentage of investment professionals these days) are least equipped to navigate on the sea of uncertainty. To survive in the entire range of environments, we need people that come at decisions from other directions – and ask those better questions – rather than trying to outthink and out-model everyone else.

Speaking of thinking, Collins grew up with one mantra ever-present in her life: “Think.” Her father worked for IBM, so she couldn’t get away from that famous slogan from founder Thomas Watson. But it’s easy to get lost in your own thoughts (sitting in your office with your electronic tools) or to get caught up in the conventional thinking about an investment question.

Thinking differently is essential (yet difficult), and Collins says we need better systems for approaching problems and better conversations about them. Long-term perspective is needed to succeed in a world driven by short-term performance.

That demands a reengagement with realms beyond the echo chamber of the investment business. In many ways, we have become removed from the reality of our decisions. A stock is not a blip on a screen but an economic interest in a company. As someone schooled in fundamental analysis, Collins stressed the importance of understanding the culture of a firm, and “you can’t do it in ten minutes.” You also can’t capture the world with a bunch of statistics, although they are an important part of the information mosaic (just not as important as we’ve come to believe).

Collins is an engaging speaker, sharing insights from within the investment business and from outside of it, and effectively connecting the two. You can’t help but think that you’d want her around the table the next time you had a tough issue to address – or when you needed reminding that sometimes you have to take a step out into the real world to see things in new ways.

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Posted in Hot Topic Commentary, Local Charterholders | Tags: biomimicry, katherine collins, nature of investing |

All Quiet on the Western Front

21st August, 2014 · John Boylan, CFA · Leave a comment
John Boylan, CFA

The 100th anniversary of the start of World War One (WWI) was a couple of weeks ago. Therefore I am reading the classic book, “The Guns of August” about the first dramatic weeks of the war from July-September 1914. Strangely enough, I did see some parallels in investing with some of the decisions made in those fateful weeks.

Years before the war even started both the Germans and the French had crafted meticulous war plans. The Germans had the Von Schlieffen plan and the French had “Plan 17” (which sounds like the title of a famously bad 1950s horror movie) which was crafted in part by Gen. Joffre. The Von Schlieffen plan required the Germans to bypass French fortifications near the French/German border by invading neutral Belgium and eventually northern France. The French, anticipating this in Plan 17, decided to attack the Germans in the middle of their lines near the Belgian Ardennes into central Germany thereby protecting France by putting Germany on the defensive on their home turf.

Early on in WWI both Germany and France rigidly stuck to their plans, which was one key reason WWI flamed out of control so quickly—those plan timetables must be met and, according to the military, should not be altered. Then as the war progressed both sides due to either favorable short term opportunities on the battlefield at the time, or out of panic by certain commanders, led to changes in the plan that were unthinkable just weeks before. This may have ultimately lengthened the war that led to disaster for both sides.

This, in an odd way, reminded me of investing. We all have investment plans and processes that we adhere. I am not talking about agreements about investment styles and parameters we have with clients/investors, which are sacrosanct. I am discussing about the way we invest, the way we think, and the way we profess to execute our plans to meet those investment goals.

Occasionally throughout the course of the investment cycle, situations arise that can cause us to consider temporarily deviating from our preferred and often proven investment strategies. One such example is what we commonly call a “trade” which is, or at least should be, a short-term bipolar event that has defined exit strategies—it works or it doesn’t and regardless it’s a short term position. Continuing the trade example, one mistake I made a while back was when a trade went against me and I did not exit. Instead, I added to the position thinking that if I liked the stock at the price I purchased it I should like it even more now at the lower price, essentially making it an investment instead of what it was: a trade. Using the WWI precedent mentioned above, I let a short-term tactic slightly change my personal long-term investment process—at least for the duration of that holding. This ended up making my longer-term objectives harder to make.

Ever since then I have tried to avoid shorter term tactics unless I have communicated to myself and those around me clearly what the short term objective is. That way I try to give myself accountability in exiting my trade timely instead of trying to justify how a trade that went bad is now an even better long-term holding. I think both Von Schlieffen and Joffre would agree.

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Posted in Freezing Assets Shout Out | Tags: freezing assets shout out, shout out, WWI |

Numbers Geek

13th August, 2014 · John Boylan, CFA · Leave a comment
John Boylan, CFA

What most lay people don’t know about people in our industry is what complete number geeks we really are. Geeky to the point where we have passionate feelings about our preferred calculator brand. For instance, we named our graduate school intramural football team “The HP 12Cs”, after our financial calculator of choice. Yes, we are numbers driven people and are passionate on how they are used in the investment process depending on where we are in the investment cycle.

One thing I am noticing talking with fellow investors is how the numbers, as measured in earnings-based valuations, are leading them to fewer potential buy candidates as the market continues to grind higher. There have been non-stop debates if the market is under/overvalued since the beginning of this rally. As usual, it depends upon the numbers you look at for your reference point. The Schiller P/E chart, for instance appears to show that the market is near the top end of its historical range.

 

Chart: Historic Shiller P/E Ratios

(click on image to enlarge graph)

Chart Historic Shiller PE Ratios_FABlog

Source: gurufocus.com

Additionally, looking at corporate profits as a percent of GDP can lead investors to wonder where the next leg of earnings growth may be.

 

Chart: Corporate Profits After Tax/Gross Domestic Product

(click on image to enlarge graph)

Chart Corporate Profits After TaxGross Domestic Product_FA Blog

Source: Federal Reserve Bank of St. Louis  

 

Sometimes, seemingly at least in part, at the expense of average household incomes.

 

Chart: Real Median Household Income in the United States

(click on image to enlarge graph)

Chart Real Median Household Income in the United States_FABlog

Source: Federal Reserve Bank of St. Louis  

 

Still others offer compelling evidence (along with several charts, see link) that the market can continue to rally. Recent positive GDP data along with good ISM data (57.1, arguably a healthy reading and up from last month) and a progressing jobs picture may support further market gains.

 

Chart: ISM Manufacturing: PMI Composite Index

(click on image to enlarge graph)

Chart ISM Manufacturing PMI Composite Index_FABlog

Source: Federal Reserve Bank of St. Louis  

 

Personal feelings on how the market will perform in the near/mid-term aside (I think we will do OK as long as the market has confidence in the Fed and its tactics and/or if it will come to the rescue every time the market has a hot lava burp), the question I normally ask myself when there is a lot of high valuation discussions is not what will the market do next, but what is the best valuation methodology to use with a given security at this stage of the cycle. Especially since so many of us need to be fully invested regardless of market conditions.

Why? Because usually when there is much debate about stock valuations being too high we investors sometimes can get caught up in earnings stories that will likely evolve beyond our investment horizon (if at all) to justify the current heightened valuation. This in my experience usually led me to two separate risks: getting led into a value trap hoping that a poorly run laggard would catch up to its peers over time or relying on earnings estimates two or even three fiscal years out.

Usually in these circumstances I tend to gravitate toward revenue based methodologies, such as price/sales and top line growth rates. I always thought that 50%+ of valuation work starts with revenues to begin with as so many estimates on all financial statements are driven by this line item. Additionally if the market continues to gravitate towards growth stocks I avoid value traps by only focusing on companies that can deliver on top line growth instead of focusing on margins and earnings that may never come. Conversely if the market begins to slip, if I focus on companies with a lower price to sales ratio, I don’t have to worry as much about discretionary actions a management team might do in a downturn such as delay or cut a stock buyback program, or what cuts they may make to “make the earnings number” in the short term but could harm future growth.

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Posted in Freezing Assets Shout Out, Hot Topic Commentary, Local Charterholders | Tags: freezing assets shout out, household income, Numbers Geek, P/E Ratios |

A Future Candidate’s Perspective: Ominous Trading Future Leaves Banks with Questions

11th August, 2014 · CFAMNEB · Leave a comment

Each season CFA Society Minnesota invites finance students to learn about the CFA Program by interning with the local society. Students assist society committees with research for their projects, and are encouraged to take on tasks that broaden their skills and industry insight. Chris Roebber will be a junior this fall at the University of Minnesota Carlson School of Management. Chris wrote this commentary with the assistance of Freezing Assets contributors John Boylan, CFA and Lissa Rurik, CFA. If you’d like to work one-on-one with a future CFA Candidate this season, please contact us to volunteer!

Ominous Trading Future Leaves Banks with Questions

Large Wall Street banks have received a lot of flak in recent years. Whether it’s been the shady mortgage dealings or the seemingly obscene bonuses of bank executives, public scrutiny has been at an all-time high. But as banks are finally settling government lawsuits from the 2008 meltdown, a new challenge has presented itself, trading volume has fallen, the floors have gone silent, and trading revenue has seen double digit percentage drops. Large investment banks’ that rely heavily on trading revenue may want to consider changing their business model as the industry is becoming far less attractive due to economic, regulatory, and technological changes.

The falling trading volume and respective losses in revenue are telling signs that the current model is in danger. Global revenue from FICC (Fixed Income, Currencies, and Commodities) has fallen 16% since last year and 23% since 2010[i]. But it’s not just FICC revenue that has been in a slump, equity trading has fallen drastically as well. This past June’s trading volume was the lowest for the month since 2006 and last year’s average volume was 37% lower than its peak in 2009[ii]. In a volume driven industry, these dampened numbers are cause for great concern. Most traders point to a “boring” economy. Everyone from institutional investors to individuals is in a wait and see approach, rather than making big bets on the market. While traders may be partially right that some of the falling volume is due to this wait and see idea, regulatory and technological changes are cutting profitability, making this more than just a cyclical issue.

Rapidly changing regulations are making the industry far less profitable for the long term. Higher capital requirements have made it more costly to hold inventory and the Volcker rule has limited risk taking and could bring proprietary trading at large banks to a halt. These regulations have added up to a lower estimated return on equity than ever before. Sanford C. Bernstein bank analyst Brad Hintz estimates Goldman Sachs’ trading division to have an ROE of 7%, significantly lower than the firm’s theoretical cost of capital of 10%. If the golden child of Wall Street is struggling to produce the required return, their competitors cannot be far behind. Regulatory changes are not the only culprit though.

Changes in technology have shrunk spreads and hurt the long-term profitability of banks trading arms. High frequency trading is changing the industry outlook and not necessarily for the better. Advocates of HFT say it adds liquidity and decreases spreads. This is bad news for traditional market making traders. With small spreads, increased regulation on risk and an uncertain prop trading future, there is very little opportunity for traders to maintain margins. I would argue then that the increase in HFT is hurting big banks by decreasing profitability of market making traders. The margin contribution of high frequency trading businesses is dwarfed in comparison to the larger traditional trading platform. Banks would much rather have a healthy equity trading business making billions then a HFT arm generating hundreds of millions. The risks and ominous future of the industry has even brought the COO of Goldman, Gary Cohn to question the vitality of their dark pool, Sigma X, in a recent Wall Street Journal op-ed.

Clearly trading divisions are in turmoil right now, from both cyclical forces driven by a wait and see approach, to long-term regulatory and technological changes. Large investment banks with the heaviest focus on trading could suffer the most. These banks should sell off their high frequency trading arms and begin to transition away from depending so heavily on trading revenue. Investment banks can consider a more conservative approach like Wells Fargo, which has a smaller investment banking arm and instead focuses heavily on consumer lending. Another option is to focus more on traditional activities like M&A advisory. But at the end of the day, the status quo cannot stay for much longer.

————————————————————-

iBurne, Katy, Justin Baer, and Saabira Chaudhuri. “Empty Trading Floors Fray Nerves on Wall Street.” The Wall Street Journal. Dow Jones & Company, 13 July 2014. Web. 14 July 2014.

[ii]Strumpf, Dan. “U.S. Stock Trading Volume Slump Continues.” The Wall Street Journal. Dow Jones & Company, 1 July 2014. Web. 14 July 2014.

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Posted in Hot Topic Commentary | Tags: cfamn intern, ominous trading future |

Proud Mary

4th August, 2014 · CFAMNEB

Corporate bond supply has trailed off to almost nothing. This week we had just $6 billion in new issue, about a quarter of which was from Credit Suisse, as the banks come back into the market post earnings. Credit Suisse reopened two existing bonds, selling an additional $750mm each of the 2.3% 5/28/19 and the 1.375% 5/26/17 at spreads of +70 and +47, respectively. There was just $65 billion in corporate bonds issued all month, and this week’s supply came to an abrupt halt with the equity market sell-off on the last day of the month.

Spreads overall were weaker, backing up 2-5 basis points. Banks and higher risk sectors bore the brunt of it, but weakness was pretty widespread. For the month of July, spreads ended up close to unchanged, and total returns were pretty close to zero – a far cry from the 5.7% for the first 6 months of the year.

We are keeping a close eye on Supply / demand trends in credit right now. We have watched the high yield market suffer significant outflows for most of July, creating selling pressure and driving total returns to -1.33% for the month. We have not seen the same selling pressure in high grade markets, where money continues to come in, but we are wary. The risk-on tone which blanketed the markets through June has given way under the weight of geopolitical pressures, economic uncertainty, and the expectation that higher interest rates are finally right around the corner.

We can’t help but feel that the river of liquidity that has been carrying us all downriver is about to dump us into the Gulf of Mexico. Being carried out to sea on a riverboat would be a vastly different end to the credit cycle than anything we’ve seen before. Everyone is so busy waiting for the river to dry up – the more typical end to the cycle – that perhaps they are missing the bigger risk. As the Fed ends QE, and moves into rate hikes, maybe we will find that shutting off the tap is harder than they thought.

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Posted in Weekly Credit Wrap | Tags: Credit Suisse, freezing assets weekly credit wrap, proud mary, Weekly Credit Wrap |

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