It's Complicated

The market will not go up unless it goes up, nor will it go down unless it goes down, and it will stay the same unless it does either.
— Adam Smith

My friend Gevas, who teaches an evening class for MBA students on International Business, asked me to chat with his students a few weeks ago about global business, culture and investing. One task he assigns his students each session is to share a topic of global financial news for discussion. On the day I joined, one of his students announced, “The market was up today because people were optimistic about Greece.” The young student felt that was logical, and he might have been right. On the other hand, there could have been any number of reasons, many having nothing at all to do with Greece, behind the market ending a few points in the green that day. As I listened to the student and began preparing my complexity analysis spiel, I knew that there was a good chance I would lose the class’ attention.

So I started simply by discussing how our brains are wired to take shortcuts when presented with complex tasks. I explained that the brain is a big user of energy. In order to “conserve” energy, we develop habits so that we can move through any analysis more efficiently. This can be dangerous in life and in business, though, as such habits can lead to oversimplification and ultimately false conclusions. I then quoted a friend and author Don Beck who said, “Complex problems require complex solutions…and we make mistakes when we try to use simple solutions to complex problems.” 

A young man in front of me was starting to doze off, so I asked him why he loved his wife. After a minute I said, “It seems insincere to try to explain why you love her, doesn’t it?” He nodded. I then said, “It’s complicated.” 

We had a good discussion that day, and if nothing else, I hope the students left class a bit more critical of the financial news they read. Better yet, I hope that they come to realize that the action of complex systems, such as those seen in financial markets, rarely can be simplified down to easily digestible sound bites, even if that’s what the human brain craves. 

Left to its own devices, the brain will try to make almost any routine into a habit, because habits allow our minds to ramp down more often.
— Charles Duhigg

Short Cut Investing

Speaking of markets ending up in the green, the very same S&P 500 stock index we discussed in Gevas’ class has had quite a run over the past few years, especially relative to more diversified global stock indices. Valuations of many U.S. stocks are approaching nosebleed levels, which is one reason we currently don’t hold large weightings of S&P-type U.S. stocks in client portfolios. 

The strong run of the overall U.S. stock market, since the trough hit during the global financial crisis, has also influenced a clear shift in investor preferences. As the chart (on the next page) shows, investors, at least those investing in mutual funds, have defected from the active style we practice at FIM Group to the passive indexing style championed by the likes of Vanguard. Many investors have seemingly succumbed to a “just index” philosophy and have adopted an approach that “owns everything.” While appearing “simpler” and “cheaper,” the passive indexing approach forgoes making the two investment judgments (investment quality and investment price) that we believe play critical roles in successful LONG-TERM investing. The growing herd of passive indexers have seemingly accepted unusually high levels of risk to their wealth as the price required for the simplicity offered by these products. In my opinion, they’ve taken a shortcut that may well prove to have significant negative consequences.

 
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“When You Know Better, You Do Better”

Poet Maya Angelou’s quote, “When you know better, you do better” sits in front of me as I type this. The quote reminds me of the importance of thoughtful analysis. Let’s face it, when an investment idea comes along, we should categorize it as a “theory” waiting to be proven as a good investment by a process. The process, hopefully honed by experience, training, education and reflection, leads to a result regarding the potential investment of BUY, or sets it aside until something happens. For example, the “something happens” might be the investment’s price gets better and/or positive developments increase the investment’s prospects. Eastern philosophies have a process – “Theory » Practice (analysis) » Realize (make real)” – that can be used to discover truth and avoid falsehood. This rigorous philosophical process of discovery also works with investing, although the ancients created it for questions like, “What is happiness?” “Why do we suffer?” and “What is our responsibility to the poor?” 

Our process, in graphic form, is obviously a bit oversimplified, as there are immeasurable inputs to the investing, research and risk-management process.

 
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Make the Decision 

Still, the job of a money manager is developing a process that helps in his/her financial decision-making. It is complex and it is dynamic. Everything about investing is geared toward making a decision: Do I look at this [investment] idea? Do I buy? Do I sell? If I do not buy it, why not? Or when? The key to the investing process, ultimately, is not the process itself, but the ultimate decisions that are made on behalf of the portfolio. Unless the process leads to good decisions and thus good performance, it is just a process that “looks good on paper.” Because investing is difficult enough, being successful requires that the investment process be part of the cultural DNA of the firm, lived by its investment team, and manifested in its investment systems.

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Complacency Is the Biggest Risk

When a company believes that it has “figured it out” and then rests back on its lazy brain habits, it is taking a significant investing risk. Research charts and written processes must be continually challenged, questioned and critiqued to protect a firm from the lazy brain complacency that can set in. At FIM Group, when we look at equity investments we always try to ascertain if management is forward-looking, growth-oriented, or resting on a few good past years or a few good products. Today, many larger companies are growing their share price by borrowing to buy their own stock – this is a near zero-sum game and artificially makes a company look successful in the short-term. It is one reason we believe that indexing is a flawed strategy today. The indexing investors are most likely in the dark about the way their companies are managed – just buying with no ongoing analysis and forgetting about it. While buying one’s own stock works in the short-term, a company’s long-term objectives should be about creating solid products, implementing great product development strategies, performing stellar research and creating value for its customers – that’s what make a company sustainable and successful. Borrowing to prop up a share price is not sustainable. 

Upon analysis, the young men and women in Gevas’ MBA class, would easily be able to see the flawed strategy of borrowing to buy and prop up a company’s share price. However, unless they look, they will not know. And if they don’t know, they can make flawed decisions. It’s complicated.