(image credit:  money.cnn.com)

We talked about what a great investor looks like, but how do we figure out who will be a good investor?  You gotta measure it to manage it, so do you look at how much money someone has made?  Their returns?  Or, more sophisticated, at an investor’s alpha or Sharpe Ratio?  These types of measures are the focus of fifty years of finance literature.  I can’t argue with their precision.  But if you care about future returns, we do know that they measure the wrong thing.

The traditional measures of investing prowess only measure the historical output.  In order to decide where to invest and create durable/improving investment performance you have to measure how the inputs make the outputs.  Just imagine sitting down with an investor for a year-end review and saying:  “Look you are doing OK, but we really need you to increase your returns in excess of the risk-free rate divided by the historical standard deviation of returns by at least 0.2 in the next year (Sharpe Ratio).”  Where would one even start with that?  It’s not actionable for an investor.  Like alpha, the Sharpe Ratio is a vanity metric – a figure that looks good for your end customers (limited partners), but has little to do with how to effectively deliver that product consistently to customers in the future.

If that wasn’t clear, consider another example, suppose GM exclusively measured their entire organization based on the finished vehicle.  In this case, vehicles would never get built because no one would know what to do.  To make the final product, you need to measure the performance of the various pieces of the production process in the ways that are under the control and are relevant to each part of the process.  People making seat covers need to be primarily measured on how many fault-free seat covers they can make per hour, rather than the JD Power rating of the entire vehicle.  If the interior, chassis, electronics, engine and assembly people are all executing well on their responsibilities, chances are they will make a great vehicle.  Not rocket science.

OK, so we don’t want to focus on the historical outputs, we want to measure how well the inputs are used, you get that.  What inputs should we measure then?  I will break them down one at a time, but to keep this short, I will give you the answer upfront and then show you how I got there.  The number one metric to measure is batting average.  Batting average, batting average, batting average.  In other words, the number of investments that an investor makes that are profitable divided by the total number of investments.  If an investor’s batting average over time is <50%, there are few ways to sustainably make money.  That is the breakpoint between success and a painful spiral.  A batting average <50% means that an investor will have to roll the dice for a few big winners and/or hope to allocate more capital to the winners than the losers.  It’s not sustainable or repeatable.

What is true about individual investors is true about investment organizations as well.  Obviously, if the aggregate investment organization’s batting average is <50%, they will need big winners or lucky capital allocation to perform.  But the batting average within the organization tells you even more.  If only a few partners have a batting average >50% or batting averages are declining among partners over time, that means that the partnership is sick.  If young analysts’ batting averages aren’t improving over time, that means the organization is not investing in training and/or recruiting.  In both cases, the great investment returns of the past are very unlikely to be repeated in the future even if the whole dollars, returns, alpha and Sharpe Ratio appear to be fine today.

It is clear that having a batting average >50% is at the core of making money investing, but is it an actionable metric?  Consider the year-end review to discuss a batting average:  “Look you are doing OK, but we really need you to increase your batting average from 40% to 60% next year.”  What do you do with that?  Well, go pick more stocks that go up than down.  What is the easiest way to do that?  Weed out the losers.  Do more of the winners.

In order to do that, you need to actually have data on when/where you win and lose.  I track my batting average by geography, market cap size, sector, industry and situation (IPO, spin-off, merger, etc…).  After a few years, an 80/20 emerges.  80% of my losses come from one particular type of investment .  So the actionable outcome is that I need to not trade those stocks or have the trading desk refuse to execute orders in those stocks.  In short, batting average is very actionable.

The readers of this post are smart, so I am sure a number of objections have started popping up in your heads.  Shouldn’t you measure batting average relative to the market?  Over what time frame should you measure the batting average?  Agreed.  So in an absolute return setting, a >50% batting average is what matters.  If you are long-only or benchmarked, then you gotta beat the batting average of the index.  If you are long-short, with certain exposure weightings, then you can benchmark against the index with those exposure weightings.  The same flexibility goes for timeframe.  If you care about performance over 3 years, then track batting average over 3 years, not year-to-year.  If you care about performance daily, then track the batting average every day.  A batting average is simple division, make it work for you.

Obviously, batting average does not = profits.  You gotta multiply the batting average times the exposure (the amount of money allocated to each investment) to get profits and we’ll go over measuring exposure in the next post.

Good investing is hard because it requires three different types of people.  You need to be creative to come up with ideas.  You need to be a diligent researcher to vet them.  And you need to be shrewd to turn ideas into money.  Unfortunately, human beings usually come with one of these qualities at a time.  For example, top-decile creatives aren’t often in the investment business.  They are artists or in an asylum.  Diligent researchers usually lack the creativity to spot opportunity or the business sense to capture the money for themselves.  Bazaar merchants are good at churning inventory, but without a structural opportunity on which to apply their skills or a filter on what they are trading, they frequently run themselves into the ground.  So you need to start by knowing, big picture, where your strengths are while tending to your weaknesses.  Tending to your weaknesses means both working on the weak spots as well as surrounding yourself with people who excel in the categories in which you do not.

In my view, it is kind of obvious that you should envision investing as a supply chain of ideas, research and making money…and then organize people around that chain based on their skills.  Folks don’t seem to talk about it this way and investment organizations aren’t structured around this reality, so I wanted to make sure I laid that out before we get into the details.

Now let’s try to figure out where your strengths and weaknesses are.  Answer these three questions for yourself:

How many investment ideas do you come up with a month that merit researching?

When you research an investment, how many different people (non-investors) do you interview to evaluate the company?

How many things do you negotiate a day on average?

In broad strokes, these three questions help me figure out the relative strengths of the investor that I am talking with.  To make this fun, we’ll make a numerical game out of it.  Divide the answer to the first question by 100, the second question by 35 and the third question by 3.  Add them up.  If the number you get is 3.  You are indeed God’s gift to investing.  The rest of us have work to do.  But now you know where to focus your attentions in terms of training and hiring in order to run a productive investment “supply chain”.

How did I get to those numbers?  The numbers 100, 35 and 3 represent the extreme best creatives, researchers and traders that I have met in my life.  Think about it.  If you meet someone who negotiates, on average, three different purchases/things a day.  That guy is a huge pain in the ass, so much so, that he barely exists in real life.  But that guy, in a narrow way, is extremely good at extracting value out of a given situation for himself.  Similarly, the person who comes up with three investment ideas a day is difficult to fathom.  They are very productive, but scattered and often referred to by their colleagues as “crazy” or “has ADD”.  If these extremes can live within you, one person, congratulations.  The rest of us, however, need to be aware of these strengths and weaknesses, and plan our network and organizations around them.

The coming posts will mainly focus on measuring yourself and your behavior accurately so that you can tell what you are good at and what you are bad at.  I hope this post provided you with a backdrop for what we are digging for and how it will all fit together.

Filed under: Uncategorized Tagged: creative, good investor, idea, investor, research, trading ]]> http://viewfromthebottom.org/2011/12/16/what-makes-a-good-investor/feed/ 0 newtome http://viewfromthebottom.org/2011/12/13/view-from-the-bottom-24/ http://viewfromthebottom.org/2011/12/13/view-from-the-bottom-24/#comments Tue, 13 Dec 2011 01:40:23 +0000 newtome http://viewfromthebottom.org/?p=167 ]]> I’m going to transition the View from the Bottom from telling you what will happen in the coming 6 months to writing about how to make more money investing.  Here’s why I am changing the focus:

The public (and private) investment business has gone from an “explorer” business where returns were so fat that anyone with a calculator, a phone and a command of the English language could make enormous sums of money – to an “exploitation” business where profits are thin and are eeked out through efficiency.  Don’t worry, this happens to every industry over time, so we know there are two implications that we can prepare for:

1)  There will be less alpha to go around.

2) Investment firms will compete on how well they are managed.  More specifically, how quickly they can discern and give capital to investors who can produce abnormally large returns.  Investment firms that can do this will attract more LP money, better people and more carry dollars to buy that house and that new pair of shoes, every now and then.  If you just thought – don’t we do that already?  You don’t.  Keep reading.

So let’s look at what investment businesses are doing now to compete on challenge #2.  Training at investment firms takes two forms, both woefully ineffective in the current environment:

1) The Osmosis Model:  A new analyst is paired with a portfolio manager and engages in an “apprenticeship”.  The analyst assists the portfolio manager in their work and learns by doing.  The observed hit rate in developing great investors in this model is low (<25%) because it assumes that analysts can tease out lessons from an extraordinarily complex set of variables simply by observation.  In addition, the portfolio manager’s and the analyst’s risk tolerance, personalities and experiences may differ and thereby greatly impede learning.

2)  The Filter Model:  Hire a bunch of analysts, give them some money to manage, fire the bottom 20% of performers every 6 months.  A few years later, you have a group of people that is either lucky, smart or both.  Again, the observed hit rate is low <25% because you have no idea who is lucky or has skill or whether the skills are appropriate for the outlook going forward.

It is easy to throw stones…so what is the better alternative?  Well, it becomes clear if you just breakdown where investment profits come from.  *ALL* investment performance, regardless of asset class, is a product of two factors:

1)  Batting average – the percentage of investment picks that are profitable vs. not profitable.

2)  Exposure – the weighting of investment picks, i.e. how much money you choose to put behind each investment.

That’s it.  Batting Average  x  Exposure = Investment Performance.  Every.  Single.  Time.  So in developing investors, your goal is really to get the team to have a batting average well-above 50% and have exposure that favorably selects the batting average.  With that, you will always make money in all market environments.  So how do you do that?  In my experience and observation, this is a result not of putting resources towards “training people”, but of figuring out what investors are already good at and amplifying those skills…which leads me to what I call the Discovery Model.

The Discovery Model:  The 1-4 year investment “training period” is far too short for someone to learn how to invest.  The only thing that can be reasonably ascertained during this period of time is what an investor is good or bad at.  In order to produce a viable batting average >50%, an investor should focus on what they are good at and stop doing what they are bad at.  This concept extends to exposure management as well.  If an investor’s exposure selection underperforms the batting average, then an investor should not select exposure, regardless of tenure.

The implication of the Discovery Model is that investment firms that can discover what their analysts are good at the fastest and allocate the greatest amount of responsibility to these skills, win.  Have you heard that in an LP meeting before?  Never, right?  You’ve probably been lulled to sleep by stories about investment process, discipline, training programs and great people instead.

This post is getting long, so I will stop here before going into detail on how to implement the Discovery Model as an individual or an organization.  Instead, I will leave you with an “Appendix” – a breakdown of my own batting average to demonstrate how this information can be used to develop analysts and wield investment research for maximum profit with minimal effort.

So my batting average over the last 6 years has been 80% and approximately 80% in each year since 2005.  This is quite high for a period where the market has gyrated between +20% and -40%.  None of the investment firms that I have worked for have gathered this data, so none of them have peeled back the data and looked to see why my batting average is so high and how it might be maintained or propagated throughout the organization.  So let’s do that now.

On the long side, my hit rate averaged about 60% during a period where the market is down.  Let’s look one step closer:  For companies that I am covering for the first time, the hit rate is about 60%, for companies I have looked at a few times before the hit rate is 80% and for companies that I have looked at for years, the hit rate is 40%.  Now that is important information for an investment organization to know.  The more I know about a company, the worse my ability to buy stocks.  So the longer I become expert in a set of companies and the more responsibility and capital I am given, the more likely it is that I lose a lot of money.  This seems strange.  But it is the reason portfolio managers and experienced investment professionals blow themselves up all the time.  The underlying cause is the human tendency to believe our own b.s.  This isn’t inherently a bad thing.  It just means, the less I invest in companies that I have gotten very comfortable with, the better I will do in any market.

On the short side, my batting average is 95%+.  Whether I have known a company for a short period of time or years, the shorts work in any market conditions.  I think this is because shorting is inherently nerve-racking and so complacency doesn’t set in.  I also have a tendency to see the worst in people and situations.  Since the point here is to become as great at investing as fast as possible, I should just do more shorts within appropriate exposures and my batting average, and likelihood of making money will go up.

What other interesting insights are there to glean from my batting average?  I have no statistical skill at determining outcomes of government regulation.  But I have a perfect batting average with IPOs on the long side in all market conditions.  This also correlates with other data that suggests when an investment landscape is undefined (i.e. there are no comparable companies, limited coverage, etc…), I am at my best on the long side.  So for me, “getting better at longs” doesn’t mean “spending more time on the long side” or “seeing the upside” or similar nonsense.  It just means focusing my efforts on buying stocks in uncertain or unusual situations.

The batting average is only half of the equation.  Selecting exposure is equally important.  I hope to cover how to gather and analyze data on both easily and systematically in the next post.

(image credit:  labourlist.org)

I am sorry I didn’t write.  I haven’t been able to use my right hand for the last month.  The truth is the worst possible answer, carpal tunnel.  A hunting accident would at least provoke feminine pity and the hope to bridle something untamed.  Instead, it looks like I am fast with my figures, but slow on my feet.

Which brings me to Europe.  The Eurozone has been pushing out press releases at a desperate pace.  Week in, week out, we get rumors of the ECB buying Italian bonds.  The Chinese buying Italian bonds.  Germany and France buying something with 3 trillion dollars.  Hope, perhaps.  But this is like playing defense in your kid soccer league- watch the torso not the feet.  The torso is economic growth; everything else is the feet.  Without economic growth, Europe can’t meet its debt obligations and interest rates will stay high and smother hope.  The arguments for economic growth in an environment with declining wages are stretched.  So I don’t want to spend much time on Europe.  We covered it; we know what is going to happen for the next 6-12 months.  The only hard part is not getting distracted from the truth.

What is really interesting is China, and I wish I could have written more about it earlier.  Yes, the stock market is down over there, but there is more to come.  Let’s look at what has happened in China to understand what will happen.  China’s economy has been rapidly growing, particularly after executing the largest stimulus in the world in 2009 on a not quite so large economy.  In order to pull back the reins, China has tried to curtail loan growth at the banks.  Unlike other economies, China controls how many loans are made by banks.  It is actually the best way to control monetary policy.  Except, that if banks can’t lend, then other entities in the economy will meet demand and start lending.  So what has happened in the last three years is that thousands of large and small enterprises have started to lend money out for projects that official banks could not lend to.  In other words, the least qualified lenders have been lending to the most marginal borrowers.  How much have they lent over the last two years?  One or two trillion dollars.  Between us, that is a lot of money.  For a five trillion dollar economy, that is a lot of money.

But no one knows for sure how much money has been lent out through informal channels, which is what makes it so interesting.  For all the attention that the subprime crisis got, it wasn’t that interesting.  You could go on Bloomberg, see all the securitizations and the underlying collateral mortgage-by-mortgage, know what was going to happen to home prices, then know what the impact of falling home prices would be on consumption and then know the impact of consumption on GDP.  In China, we just have no idea.  Analysts are publishing many numbers about the informal lending sector, but there are no official figures.  We simply do not know how big the problem is and China is also lacking dozens of econometric studies exploring the effects of leverage on real estate prices, real estate prices on consumption, consumption on GDP, and on and on.  They’ve had private property for 10 years, total.

However, there are a few things we can know about China.  First, it is highly likely that informal lending is at least 10% of Chinese GDP, which would make it double subprime at the peak.  Unlike subprime mortgages, the informal loans are working capital or property development loans, which means they are short duration, highly cyclical  and need to be constantly refinanced.  This means that, if we have a problem, we’ll experience it quickly.  Like, over the next 12 months, not 3 years as was the case in the subprime crisis.  We also know that the collateral (inventories and incomplete construction projects) is worse than that of the subprime mortgage market.  We also know that the Chinese government is taking steps to prevent informal lenders from foreclosing on projects, which is good in the short-term, but it means that fewer new informal loans will be made.  This is bad because if a whole portion of the economy exists because informal loans can be refinanced, then a meaningful portion of the economy will be stripped of its oxygen supply, shortly.

So what we can conclude is: that the up-and-to-the-right-line that China’s growth has tracked has had some support from an exponential growth in lending.  The trips to Macau, the handbags and empty condominiums were made possible by artificial growth in leverage.  So the correct growth trajectory for China is not 8%, but some number of degrees lower.  If M2 (money), doesn’t grow at 30% anymore, but instead grows at 10%, does the Chinese economy continue to grow at 7-8%?  Maybe, anything can happen.  But not ever before has a sharp downward change in M2 been accompanied with constant economic growth.  Nevertheless, for the moment, China and its strategists are sticking to the 7-8%, with the caveat that all bets are off if the US and Europe go into recession.  Great, so we know all bets are off.

The implications of a low-growth Chinese economy with a negative interest rate environment over the coming decade will have to wait until next time.  Sorry to hold you in suspense.

Jobs.  It’s not about jobs; it’s about productivity growth.  Productivity growth is the key to understanding where this nation is headed over the next decade.  Right now, I know we aren’t headed in the right direction because the focus is on jobs.  This isn’t an indictment against President Obama, but rather both Democrats and Republicans are wrong for focusing on the wrong thing and it will cost us another decade unless policy changes fast.

Let’s reverse the “jobs debate” to see why it doesn’t make sense.  Do Americans want jobs?  No, not really.  Step back for a moment – Americans don’t want jobs, they want money, a home, a good-looking wife and maybe a nice pair of shoes every now and then.  How do Americans get money?  Well, by borrowing, but the only way to make money sustainably is to get a dollar out of your customer’s pocket for less than a dollar of costs – even non-profits have to do this too.  Humans are competitive, so to make money over time you have to be harder working, more efficient, or think of ways to make money that others haven’t thought of yet.  That is productivity.  Have we used the words “jobs” yet?  No.  We shouldn’t confuse jobs with making money; they are two very different things.  People making money make jobs.  People making jobs that don’t make money makes Michigan.  So until the debate and economic policies shift to productivity, all roads lead to Lansing.

That’s why Democrats are wrong for trying to create jobs with job creation tax cuts and construction programs.  Those programs will certainly create some jobs temporarily, but that is not the point.  We shouldn’t borrow from our children to boost quarterly job numbers.  We need more people working because there is a profit to be made from pulling a dollar out of a customer’s pocket without government subsidies.

Republicans are also wrong for blaming Obama for creating an unfriendly business environment and stifling job growth.  Do moneymakers wake up in the morning and say to themselves – my marginal tax rate may be 3% higher in 3 years, let me not try to make money, buy a home, get a good-looking wife or buy a nice pair of shoes every now and then?  Let’s be honest, with the money in your pocket, a postage stamp and a printer, you too can start a company in America.  But before you hire anyone, you need something and someone to sell things to, and without a long-term rise in aggregate demand due to productivity growth there is no other way that is going to happen.  With or without Obamacare.

Europe.  Imagine if the Canadians controlled the Federal Reserve and every state legislature had to vote unanimously for TARP and any other spending measure.  Would 2008 have gone down differently?  Yes.  So that’s one of two problems that can’t be solved in Europe – Europe has high coordination costs at a time when decisive action to restore confidence is necessary.  Case in point today, Germany was supposed to vote on Europe’s “TARP”, but they are pushing the vote back to next year.  That’s just one of seventeen countries.  Meanwhile, back at the ranch, Rome burns.

The other unresolvable problem is growth.  European TARP may get done, the European Central Bank may print money and the stock market could go up 20% as a result.  That may all happen in the near-term, but come next year, all sentiment will be determined by Spanish and Italian economic growth figures.  Why?  So far, everyone is assuming that these Eurozone countries will grow.  That is why austerity programs are getting pushed off to 2013/2014 – to allow for some growth before austerity reduces growth.  But if these economies start to shrink in the face of growing liabilities BEFORE austerity measures kick in, it doesn’t matter what any central bank does, there is no sustainable solution.

So will Spain and Italy grow?  That is the $1 trillion question.  Well, Spain’s plan for growth is to become more competitive.  In English, this means reducing wages (now) to boost exports (over the next 10 years).  What happens when you cut wages on a levered consumer?  They stop spending, which leads to negative GDP growth in the intermediate term.  Italy’s consumer is not levered, so the impact won’t be as dramatic there, but negative in the interim nevertheless.  If that isn’t convincing, let’s step back from the economics for a moment and just answer this question- when is the next time you’ll buy a Spanish or Italian export?

We’re going to need to buy a lot more than a nice pair of shoes every now and then.

Default – not getting a debt limit deal done – is a different story all together.  The US Treasury not paying its debts may mean your wealth changes by an order of magnitude and your ATM card stops working this week.  You can see the first signs of this happening in the funding markets last week.  To make sense of the funding markets – a quick explanation of the way these markets work in 50 words:  there are trillions of dollars of assets at banks, mutual funds and companies – rather than moving these assets around constantly to do transactions or borrow money, which would be cumbersome, these institutions leave the assets alone and instead pledge the assets as collateral in exchange for cash to do whatever needs to be done day-to-day.  Sort of like if you had a house, and needed to pay a $1,000 bill before payday – you wouldn’t sell the house to pay the bill, you’d just borrow $1,000 against the house until you got your pay check.  This is called a “repurchase obligation” or “repo”.  If there is no debt limit deal by Monday morning, the “repo markets” will be the news, here’s why.

This past week was an important time for the repo markets because non-bank financial institutions that usually borrow for 30 days had to do their borrowings by month end (Friday).  30 days from now means August 31st, so after the August 2nd debt ceiling deadline.  This crunch at the end of every month usually pushes prices to borrow for 30 days up by .03%, but at the end of last week it moved out by .30%.  This change in pricing was worse than during the financial crisis.  Despite this shock, all was calm elsewhere in the markets on Friday because the big boys of the funding markets – banks – primarily borrow “overnight”, so their repo borrowings on Friday were mostly for August 1st, before the deadline.  It’s not really clear what will happen on August 1st in the afternoon, when the world financial system tries to borrow trillions for August 2nd, pledging as collateral securities that may be in default the next day.  These repo markets is what did in Lehman Brothers, Goldman Sachs, Citigroup and others during the financial crisis.  If counterparties don’t really believe/like the collateral you are pledging, the game is up the next morning.

There is talk that the US can prioritize payments and pay its debts for a short while, but it’s hard to imagine this will be acceptable to the markets.  Fixed income investors are often faulted for their lack of imagination, but they aren’t stupid.  This is an old trick that every company in the deadzone – including Lehman – has tried.  It’s not a slippery slope for a company that briefly stops paying its employees, it’s a cliff.

What will actually happen without a deal on Monday morning?  The value of assets will probably decline throughout the day.  A bit more cash will be found to push out the August 2nd deadline and a deal will get done because constituents’ savings will decline in value rapidly.  With TARP in 2008, an intransigent House of Representatives voted it down – the stock market fell ~10% – and TARP was passed a week later.  I’d expect replay.

Distant from the debt ceiling headlines, the economy is plodding along, but still at a stalling speed that is below expectations and certainly below projections that justify the current market P/E multiple.  Technology companies are seeing orders moderate and valuation multiples are contracting.  Industrial demand is ebbing across the board.  And financial services firms continue to shrink in a low interest rate environment.  There is no escaping the economic math that financial services and real estate are the largest contributors to US GDP by a wide margin  - the 80/20 of the US economy.  So it’s hard for other sectors to perform for an extended period of time without a recovery in the core of what our economy has become over the past 40 years.  Of more than passing interest, the stock market remains at cyclical highs.  Sigh.

We know the sky is not falling because we can see home prices behaving in the normal seasonal pattern of the last 50 years – rising into April, May and the summer on a month-over-month basis.  That doesn’t mean they are going up over time; it just means we don’t have a repeat of 2010 or 2008 where housing prices fell (month-over-month) throughout the summer and the government had to step in to save asset prices and bank balance sheets.

You read that the auto-related supply chain is shaky, which is true, but demand for non-auto related durable goods is just fine.  And let’s not forget that autos had earthquake disruptions and a fantastic run in demand last year.  Fantastic runs are often forgotten and incorporated into forecasts.  So considering that autos saw demand in 2010 ahead of other durable goods and 2011 is a normalizing year, autos are doing just fine.

Employment was another sore spot in May and June, but I don’t see it as much to get worked up about.  Employment data is very volatile and the 3-6 month forward indicators of employment that I put together all seem to be just fine.

The hysteria over three bad data points in one month – housing, autos and employment belies a different problem.  There is no growth outlook that holds water.  When I say the outlook is “fine” do I mean +0% or +5% like the good old days?  I mean closer to +0%.  So we find ourselves in limbo – the sky is in tact, but there is also scant hope for double-digit earnings growth without further operating margin expansion or commodity price inflation.  The markets seem to be trying to figure out if long-term earnings growth will be low single-digits or high single-digits and whether it is still appropriate to pay a double-digit P/E multiple for this kind of outlook (n.b. for all of the sticklers in the audience, I mean S&P 500 earnings growth excluding financial provisioning reversals).  Market multiples and media rhetoric are just expanding and contracting month-to-month depending on which camp is winning out.  This makes large cap beta investing hard (where most equity funds are allocated) because unless you trade these swings aggressively or know whether the S&P is going to grow earnings 3% or 8%, it is difficult to generate returns that stand out.  I don’t know how to do either, so let’s move on.

We’ll wrap it up with technology.  I get questions about the tech bubble all the time.  Is it a bubble?  Let me ask you this – how hard do people think it is to make a $1 million in tech these days?  Making $1 million should be hard.  Unless you have exceptional talents at getting money from customers or your parents have a billion dollars that they plan to give you, making a million should take about a lifetime or longer.  Are people pouring into Silicon Valley because they are planning to grind out a professional education and career making communications/entertainment products for customers over 3 to 4 decades.  That isn’t the impression that I get.  It’s not kind of like when people who barely graduated from college were answering phones on fixed income desks in 2005 for $1 million a year; it’s exactly the same.  What is puzzling about the tech bubble is that folks get so worked up about the fact that it is a bubble.  Whether a sector is in a bubble or in the 7^th circle of hell (read:  financial services), there is the same rate of opportunities to learn and invest.  Despite what you read about valuations, there are very smart technology investors out there doing their best.  If there is an investor in technology companies that has a lot to teach us, it is Paul Graham.  I wanted to take the conclusion of this View from the Bottom to highlight a series of interviews he gives with technology companies in a video that can be found through this link.

Good investors are good at asking questions.  This is their craft – pushing, listening, pushing, listening until they arrive at the nugget of truth in an opportunity.  While many of the questions Graham asks are obvious, you can see how skilled he is at leaving everything in without leaving anything out.

I’d summarize his line of questioning with each entrepreneur as follows:

1)  What is this?

2)  What does it do and who uses it?

3)  What does it do and who uses it really?

4)  Let me repeat back to you what this is and what it does to make sure I clearly understand it, is that correct?

5)  What is the hardest part of getting this off the ground?

6)  Is there nothing else that is hard(er) about getting this off the ground?

7)  What is the easiest way to do the hardest part?

8)  How do you get users to discover and engage with the site over and over again.

In my view, more than half the magic comes from questions #1-#4, which most of us are too bashful to ask because we don’t want to seem ignorant.  Instead we jump in around #5 and try to show how great we are at problem solving.  When was the last time you walked through #1-#4 in a management meeting?

The usual post will be up at the end of the month.

For those not in the investment business, high correlations are blamed for low returns because high correlations imply that macro forces rather than individual stock-picking skill are driving results.  Let’s take a brief look into history to see if this makes sense.  Periods of high correlation uniformly occur when there is stress or volatility in the market.  The actual cause of this high correlation is that everyone sitting at a trading terminal is hitting the SELL (S) button as fast as they can at the same time.  So regardless of the underlying performance of a company, the company’s stock will go down because all stocks are receiving one uniform pricing command S-S-S-S-S-S.

So what about in a period of low volatility, a lack of stress, you can have high correlations then too right?  Well no, not really.  Not even during times of “quantitative easing” or monetary expansion?  No, correlations in stocks have historically gone down during those periods.  The mechanism for this is as follows.  During times of low volatility, there are few big moves in stock prices because there is a healthy push-and-pull among market participants to set prices.  Based on diverse future expectations of stock prices, traders punch in BUYs and SELLs, B-B-S-B-B-S for a given stock – generating low volatility and lower correlations.

You might say – well that may be true, but if macroeconomic forces overwhelmed individual company performance, then correlations should be high.  Perhaps, but to be more precise, correlations should only be higher because investors are all expecting that others will punch in the same series of BUYs and SELLs.  In other words, the actual cause of this isn’t the macroeconomy- it’s that investors all expect the same series of BUY and SELL orders to be entered.  Or to be really blunt.  Everyone is thinking the same.

The fact that everyone is thinking the same has little to do with the macroeconomy.  Twenty years ago, the US was in a serious macroeconomic malaise caused by a real estate bubble where government decisions would determine financial outcomes – and correlations were 75% lower than they are now.  Everyone is thinking the same in the equity markets because we share the same instant information, tools, training and worldview – or at least most incremental buyers do.  This alternative theory on why correlations are high would be supported by the general drift upwards in correlations over the last 20 years – a time period that has seen a proliferation of information, tools and the modern value investing approach (who isn’t a value investor nowadays?).

Another hint that this perspective might be right is the fact that “value” investors are going to jail.  The current tools of  the value investing trade were developed in the early 1990′s.  Financial analysis with spreadsheets, channel checks and meetings with management were the formula for making money.  If you could get access to those, there was alpha for the taking.  Reg FD put a wrinkle into this game plan and correlations in stocks have been rising almost inexorably since then.  And now we’ve hit a wall, where investors use the same tools in such a similar manner, that some funds are finding themselves bumping up against the legal limit in order to keep their LPs or egos happy.

This isn’t that crazy of an idea; this progression has happened to every investment style over time.  Before long/short hedge funds drove “value” investing to its edge, quantitative funds in the 1980′s generated alpha because they could use computers.  This edge was gently eroded away over time and quant funds have had to push into leverage and the more obscure corners of the capital markets to make meaningful returns.  Or value investors in the 1950′s could outperform because they asked for company annual reports and read them once they received them in the mail.  This is NOT to say that it was great in the good old days.  Just the opposite, all of these ways of investing seem “easy” or quaint in retrospect, but at the time, they were revolutionary.  Which is why folks made a lot of money exploiting these strategies.  What we can learn from this is that sitting in 2011, hoping that correlations come down so that value investors can make money again, is not a winning strategy.  It may pay the bills, but it is probably not a winning strategy.    In order to win, investors will need either new information sources or different tools in order to jump over the wall and start printing meaningful alpha again.

What new sources and tools are you developing?

Let’s look at the wrinkles in the supply chain and what they mean.  One of these wrinkles is in commodities, which are plagued by inflationary pressures.  These pressures are sure to abate, because inflation is already high – so a year from now, the logic goes – inflation will increase at a lower rate.  This is the basic thrust of economic predictions on inflation that the markets, particularly in Asia, are trading on.  These predictions aren’t right because inflation doesn’t have to do anything – it doesn’t have to go up less than the previous year and it certainly doesn’t stop going up because it is “high”.  Another misconception about inflation is that food prices cause inflation. Food prices are certainly part of the CPI index calculation, but they are not the cause of inflation.  Just the opposite, food prices are an outlet for the root causes of inflation because food is the most ubiquitous, price inelastic good in an economy.  Put in plainer terms – if food becomes more expensive, everyone will pay more for it, so if there is upward pressure in prices in an economy, it will show up there first.

So let’s peel back the causes of inflation to understand what is going to happen here.  The proximate economic cause for inflation is that the supply of money exceeds the productive uses for money.  The reason that, currently, the supply of money exceeds productive uses for money is that the primary economic participants in the world (US, China, EU) are trying to devalue their currencies by printing more money.  The reason that these economies are printing more money than they need is that by lowering the value of the money, a given country’s goods/services are cheaper than those of other countries plus the eroding value of money erodes the value of debt denominated in that currency.  The reason countries want to do what I described is because government regulators allowed a debt burden that is in excess of what economic participants can pay.  The reason governments do not force the repayment of debts and would rather erode the value of debt through printing money is because governments are run by groups of human beings.  Groups of human beings prefer to do what is easy rather than hard.  So, what aspect of the root causes of inflation that we just walked through are going to change in the coming year?

The fact that inflation is not going away is meaningful because inflation causes many wrinkles in the supply chain and economic activity.  One common cause is the faltering of unstable political systems.  Because inflation is manifest in consumer staples in the greatest magnitude, inflation has a tendency to making people angry at their governments.  This is the case in the history of every country from Tiananmen in China to France and the United States.  A less obvious result of inflation has been an increase in container leasing prices.  Container leasing prices are nearly doubling on an annual basis.  On its face, this is puzzling, because containers are generally not used to ship the commodities that are currently rising rapidly in price due to inflation.  So how could this be?  Turns out that higher oil prices caused by inflation are pushing shipping lines to focus on fuel efficiency.  The easiest way to run a ship more efficiently is to slow it down.  Slower shipping routes means a certain batch of goods needs each container longer to move down its particular path – creating a shortage in containers.

Similar non-linear effects are occurring in the supply chain due to the earthquake in Japan.  Big earthquakes happen all the time, but an earthquake this big has never come close to hitting such a populated area.  So it is not surprising that swaths of the Japanese supply chain have shutdown.  If it were the earthquake driving the plant closures, we might expect plant openings soon.  But what is surprising is that the majority of the shutdowns have little to do with the earthquake or the nuclear meltdown.  The reason that there are factory closures is that there is insufficient power available to meet residential and commercial needs.  The lack of power is due to the nature of the Japanese power grid.  In Japan, power is transmitted at different frequencies in the north than in the south, so the excess power capacity of the south cannot be pushed up north.  So this wrinkle is the cause of the disruption in the specialty parts and chemicals technology supply chain.  It is also the reason the problem will not be resolved quickly regardless of the nuclear fallout, the current object of the media’s desire.

These non-linear effects are all around us and they are a deep pool to find investment opportunities.  If you look around, what are other developments that are causing non-linear chains of events that are not well-understood? Here’s a simple one:  the iPad vs. the iPad2.  No, I am being serious.  I dislike Apple products, but there is a  meaningful difference here, which is the additional inward facing camera.  What does this second camera do?  Well, it lets you conveniently transmit your reality in HD to any screen in the world.  Why does that matter?  Because it will lead to the flowering of a multi-billion dollar ecosystem of augmented reality products in the coming year – from a graphic-based version of twitter, to the ability to try on clothing with anyone, anywhere in the world without leaving home, to gaming.  I hope that made some sense.  I’ll try posting an example of what I am talking about if I can find one or when I finish the one I am building in my free time.  This is the catch with these non-linear chains of events, they usually don’t make sense until they happen, at which point they are obvious.