Monday, October 13, 2014

"Seer sucker theory and my investment philosophy"

Monday, October 13th 2014

Every once in a while, the financial media gets enamored with catch phrases that subsequently become hop topics and most current risk factors for the market. After a while, but not before extracting its toll on asset prices, these flash in pan risk factors disappear from collective memory.As i write this note, the most recent one being last weeks IMFs warning about downside risk to Global economic growth forecast for CY'14. And its subsequent toll on world equity and commodity prices.

Now, I have been following IMF Global Economic Outlook reports for some time, and one thing that I can tell about these reports is: That they are usually a medium term extrapolation of what is current ground reality. Secondly, IMF is a specialist in listing all possible risk factors on the horizon and then caliberating the mood in its quarterly reports based on the importance it gives to some of these risk factors. That methodology makes IMF reports good source on analysis of the current environment but lends little credibility in correctly predicting future course of action. (Now, is that not true of all analyst, well including myself!). 

The real reason why market participants react to IMF warnings is mainly emotional, and can be explained with what behavioral economist like to call 'availability bias' and for some it is simply trying to pre-empt the rest by reacting (even blindly) to the reports' headline! As the inertia gathers momentum, the warnings actually turn out to be self-fulfilling prophecies. In that context, IMF would rather be serving the global community a service by not publishing any reports at all. But for that to happen, the ivy tower economist at IMF and such other institution have to accept that they may not have any durable edge versus the rest of the us in predicting future. And in most cases, the fact the future cannot be predicted. Current predictions are little more than approximation of the current collective emotional state of mind and status quo. With that belief, I set out to do some googling and came across and interesting paper "The seer-sucker theory -value of experts in forecasting" by J Scott Armstrong published in 1980. In a nutshell the paper concludes and I quote 1) No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers. 2) Expertise beyond a minimal threshold is of little value in predicting more accurately

I could immediately identify with the conclusions of that research paper. It also helped me outline a investment philosophy that I would eventually want to internalize and implement in taking investment decisions. That philosophy is
1) Future forecast are unreliable and/or of little practical value, except when these forecast (no matter how poor) can gather enough publicity to nudge public opinion in its direction (a clear example of the same being: controversy over climate change)
2) If future forecasting is of little relevance, on what premise/framework should investment decision be taken? In my view, if one believes in the above research findings, investment decisions should be based on 
a) current misallocation (eg. Japanese 10 yr JGBs yielding 0.6%) where the current situation is extreme to past history or reasonable expectation about future. Or where current data and projections implied in current price about the future are out of sync with one another (example the valuation of India listed cos. called Justdial)
b) When arguments justifying current valuations are largely based on complex future multi year forecasts 
c) Special situations which are not properly understood by market participants or entail significant emotional control that average market participant is unable to have 
d) investment decision that require only simple logical scenario modelling and conclusions which are readily intuitive and acceptable (eg; Warren Buffets reasoning of buying a farmland in '86 based on simple assumption about yield and crop prices)
3) Ability to accept disconfirming evidence and not get overly committed to our own prior beliefs (guarding against self-confirming bias)

Although the philosophy is well articulated above, the real challenge is to stick by it in thick and thin. Some of the above suggestions require significant psychological and emotional strength. And it is very challenging to remain true to the philosophy when managing external capital or working under an organizational setup where the investment philosophy is starkly different.

(all feedback welcome)

Siraj Presswala, CFA
San Diego, Monday, 13th Oct 2014. 

Thursday, September 25, 2014

The Gold price conundrum and coming bout of inflation. Oh really?

Thursday, Sep 25, 2014 (2:10 pm) San Diego

For atleast past two and half years, equities world over in general and US in specific have been influenced to a large extent by the Central Bank action and speculations regarding the course of the non-conventional monetary policy and its ultimate outcome. Pundits on both side of the aisle have had their own opinion in support or against FED actions. Though both (for and against) arguments are equally logical and potent, it is hard to take sides. Remember how Gold first outperformed (until end 2012) and then underperformed, in absolute terms, based on which side of arguments the general consensus approved of at a point in time.

When money printing seemed like a habit with no end (between 2011-2012), inflation mongers took refuge in Gold to preserve purchasing power. Gold bug argued that Central Banks if, intent on debasing paper money, will eventually succeed in doing so. In which case, money will loose its purchasing power vis-a-vis Gold. The evidence presented to corroborate the argument being, historical periods of high inflation triggered by loose monetary policy and Gold coming out as a winner in term of preserving real purchasing power during such episodes of inflation. When fear ruled supreme, Gold continued to do well and the hypothesis being vindicated.

When former FED chairman Ben Bernanke hinted sometime in Sep of 2013 of rolling up the game over a reasonable period , Gold started loosing momentum. In fact by end 2013, the mighty Goldman Sachs termed short Gold position as a 'Slam dunk'. The argument being extinguishment  of actions to debase currency, takes the punch bowl away from inflation mongers and hence invalidates the hypothesis in favor of investing in Gold. A secondary and smaller argument, being rising value of USD post the QE era also subverting price growth in USD denominated assets such as Gold.

Gold lost some of its sheen in 2013 having provided negative returns for the first time in any calendar year since 2002. So where did the inflation mongers go wrong? Did they not expect FED to stop some day? Did they not expect inflation in the short term remaining subdued due to the moribund employment and economy, plus the deflationary impact of govt and private sector deleveraging?

Answer to all of the above question requires no special intellectual faculties. Simple common sense and simple logical inferences would suffice. Lets start with the first of the two: It was reasonable to expect the FED to stop somewhere and at sometime. Even if no view is taken on how long they go before they stop. To make this point of thinking intuitive, let us for a moment assume, that the FED does not stop ad-infinitum. That would be the case only when the argument for QE remained valid (that being a hypothetical scenario where the economy would never return to a state of full employment). Resultantly, if the economy never gains the traction as desired by public policy, it would be hard to find a argument for inflation running amok in such as scenario. So we can infer here that if FED were never to stop than inflation or Gold would never hit the roof.

Now, it is possible that the inflation mongers did anticipate FED to stop at some future date but also anticipated the interim term to be so long and the magnitude of debasing so high that inflation in future would indeed be a high probability event. However, in that case, they implicitly are maintaining the position that: 1) Both, inflation will be persistently quite high for given period of time and Central Bankers will not be able to control high inflationary expectation by any policy tool.

If their view on any of the determining factor such as: 1) level of inflation 2) The period of sustained high and uncontrolled inflation 3) Policy tool ineffectiveness, is inconsistent with the original argument (that FED will some day stop and we will still have high and uncontrolled inflation in future) than the whole hypothesis is again under the scanner of critical cross examination . Lets go a step forward and assume that the view on the above determining factors is consistent with the hypothesis. In such situation, the analytical framework beneath the hood becomes quite complex. As complex assumptions have to be made about time horizon (persistence), level of inflation (magnitude), what constitutes high inflation compared to normal inflation in some future environment, Government fiscal and monetary policy response and Global trade and currency dynamics.

Although this all may sound little verbose, in my opinion, anyone who think that inflation is coming but also opines that QE will stop some day, is in effect consciously or unconsciously having a position on the above further assumptions. That level of prediction is far more complex than the starting notion of monetary debasing leading to future higher inflation and loss in purchasing power of paper money. The more factors involved, the more interrelationships to think about and the more stochastic the range of ultimate outcome becomes (increases error rate).

Coming to the second question of expecting short term inflation to remain low due to moribund economy and deleveraging, but however, expecting high long run inflation; brings us to an important juncture in our analysis. That being whether sharply appreciating Gold prices between 2009-2012 could withstand the continuous negative reinforcement in the short run of low realized inflation? What would happen to mass psychology in that event, would they stick to the original hypothesis even when proved wrong (even if only in short run)? Where goes the consensus, so goes the price. And this is what has been observed in case of Gold prices and investor interest in Gold between 2012 and 2013 end.  Even though the hypothesis of long run inflation without short run inflation were to remain true, it is not a necessary condition for Gold prices to keep creeping up. As one group of investors would reverse the trade mainly because they cannot have the patience of waiting for the long run. For most investors on the periphery, if there is no inflation today than there is not reason to remain invested in Gold.

In my opinion, this is exactly where lessons from history diverge from investor mentality and asset return today. Investors get into the bandwagon giving historical evidence of why the thesis should work, but forget that historical time horizon of couple of years in making is different than the daily, monthly or at best yearly time horizon that consensus price determining opinion has.  Another way to put it is even if a particular view in context of historical study is logical and might well come to pass, investors also need to have time horizon in line with that view. A shorter time horizon can lead to being wrong in the interim. And being wrong can put immense peer pressure on changing the course (self doubt).

This also brings me to yet another insight. Given the dynamics and complexities involved, in determining long term future and all together different set of dynamics and challenges (both practical and psychological) involved in sticking to an investment strategy consistent with those long run expectation. I believe taking investment position based on such line of thinking can be self defeating. I however caution that does not mean a bias towards short-termism or prejudice against long term investment outlook. What I mean is that it can be very difficult to make accurate long term assumptions (no matter how cogent the argument may sound).. More so when implicitly you are unconsciously making further assumptions and unknowingly increasing the error rate. At the same time committing large part of the portfolio that is benchmarked incorrectly (by you or the outside world) to such a position.

To return to our Gold conundrum, I think Gold price will increase when there is an actual evidence of high and persistent inflation and failing policy tools to control it (irrespective of the starting price of Gold). That is to say, that currently high realized inflation will lead to current positive return on Gold prices without much ado about prognosis few years back. Or if the consensus opinion again shift in favor of coming bout of inflation, even if only for a while.

It is hard to say what determines consistent success in the field: Whether it is ability to correctly draw long term trends and forecast (from the above I think it ain't); Whether it is ability to patiently stick to your conviction without getting distracted with short term outcome (it could, but it also poses the threat of self confirmation bias) or Whether it is about understanding and correctly anticipating consensus fears and concerns?

(all feedback welcome)

Friday, June 6, 2014

China and the value trap

The above chart shows how value added (or alternatively excess returns) is distributed across the Global electronics industries. Although, it reinforces what we already know about it for long, the chart allows for more deeper analysis. After looking at the below chart, it strikes to me that most of the world's most successful businesses have followed this operating model for atleast past two decades and some for even longer, examples include Coca Cola; VISA, Qualcomm, Apple, Cisco, Nike, even Colgate and P&G, 

Strikingly, firms in the hi-tech business that were active across the value chain (including manufacturing) are experiencing or have experienced problems in the past, examples: Hp, IBM, Intel, almost all Japanese electronic firms. One reason being, their investors primarily value them as hi tech companies rather than low tech manufacturing hubs which is sometimes untrue when low value add is more of the revenue mix than high value add. 

A modern company contradicting this trend and still steeply overvalued is Amazon which is diversifying from high value added activities (its potent online platform) into lower value added and more capital intensive ones (company owned warehousing and now logistics). It will be interesting to see whether Amazon proves to be an exception to the rule or will its market price react to this trend over time (now that is a short idea!). 

(Aside: This also reminds me of our original investment thesis in Aramex (high on brand, low on capital intensity), and why Aramex is truly under-appreciated.)

Infact, in Emerging countries there are many instances of listed entities moving from high to low value added. Usually, the devil lies with the initial success, as cash builds up, management in companies with poor corporate governance and shareholder monitoring, are motivated to reinvest the surplus and grow the size of the firm than to distribute the same to shareholders. Expanding downhill is more easier and certain than uphill which makes the decision look prudent for time being and safer for incumbent management. 

It also tells me something interesting about China and how probable it is for that country to make into the upper echelons of the income pyramid. China over the past three and half decades has grown mainly by becoming the workshop of the world -the activity which has least value addition across the chain. That success was made possible with fortuitous combination of 1) large initial supply of cheap factors of production Land, Labour and Capital. Being a authoritarian state, the government owned the land, made capital cheap by repressing market clearing interest rate (which also explains the real estate bubble in China). In an urgency to get unemployment and poverty down for hundreds of million of unskilled people after "The Party" came to power, what better than create low skill, low pay jobs by creating subsidies manufacturing base. Externally, this process coincided with the trend of rising Globalization and economic integration in 80s. 90s and 2000s. 

However, China has not been able to move upscale to more value added activities and it is likely that when the wind is out of the sails on the initial trigger factors (labour, land and capital), China will increasingly face the same risk that other middle income countries face -of stagnant incomes. Infact China's case it will be even difficult because liberty and freedom are prerequisites for providing the environment to innovate. Now, that tell us that whether "The Party" will have to go or Chinese aspirations will have to settle for less. 

The GCC economic growth in many ways is similar to that of China, given almost all GCC countries are authoritarian states of varying degrees. A large percentage of non-oil, non-consumer services GDP comes from low value add manufacturing in industries such as petrochemicals, aluminium, fertilizers, steel, etc. These sectors are globally competitive as long as they have access to cheap feedstock. Though the GCC is lauded for its economic stability and growth rates in excess of 5% and the bureaucracy extolling the growing role non-oil sector. The concerning point is that the non-oil sector is viable to a large extent only due to the indirect subsidies and surplus from the oil sector. That dependence on oil and how fast non-oil GDP can crumble when oil is removed from the equation, justify why long dated GCC assets (high duration bonds, equities and real estate) should correctly trade at a discount to other countries with similar growth but without the oil induced distortion. 

This line of thought also explains why Mr. Alabaar's (Chariman of Emaar) proclamation of Dubai real estate trading at a discount to London or Singapore should be taken only with a grain of salt. A large grain indeed!

Wednesday, April 16, 2014

The state of Indian Democracy

India heads for the biggest and greatest democracy show in Apr-May 2014 as the country of 1.2bn and registered voters of more than 800M goes to elect its new government in the center.

The election this year is very unusual and interesting from the past precedents. This years election is focused more on individual personalities that would potentially lead this country of old civilization and young population out of the longest period of moribund since early 1990s. At the center of this high pitch drama is Narendra Modi, the decade old recalcitrant Chief Minister of the western Indian state of Gujarat largely credited with engineering one of the fastest state level GDP growth.

Narendra Modi has also other feathers in his hat than just Economic development ( a preception that is selling like hot cakes in India as the country rellies from one of the slowest growth in more than a decade, rising inflation, unemployment, and never ending goverment goof ups driving scarce capital). Mr Modi is largely perceived as having covertly been a accomplice of the 2002 pogrom of the Muslims (13% of the population) under his watchful eyes in his state in 2002. A accusation that he has neither accepted and never rejected. A Supreme Court enquiry let him off the leash largely due to lack of substantial 'evidence' though the US Govt revoked his US visa and banned him from travelling to the US due to his alleged role in the genocide.

The whole campaign of the right leaning, nationalist Bhartirya Janata Party whoes PM candidate is Mr. Modi is foused on this superlative economic performance of Gujarat attributable to solely and squarely to the leadership, vision and dicision making skill of Mr. Modi. We will not go into cross examining the authenticity, and statistical analysis of that perception  here. Though sufficient to add in this context, that Gujarat has historically been a state with GDP growth higher than that of the aggregate India and Modi's autocratic and dictatorial style has earned Gujarat capital investments from national and international businesses at the expense of sidelining (sometime by force and other coercive methods) other interest-such as displacement of poor, land acquisiiton, environment, etc. A heavy handed approach indeed has its benefits, particularly in terms of raw economic growth as reflected in the 'China Model'. However India's political and economic setup is very different from that of China (Indian is the worlds largest democracy and China is the worlds largest communist). Albeit the only similarity between the two is entrenched political corruption, rent seeking and the nexus between the businessmen and politicians.

What is very puzzling and equally disappointing is that millions of Indias support Modi (including millions who knew nothing much about him and his achievements before his candidature for the top post) with the same fevour as they support their national Cricket team (India has almost no sport to talk about except Cricket). What they fail to realize is that they are choosing a leader to head a democratic country as vast and diverse as India, someone whoes values, past track record and very achievements are precisely an antithesis of democracy. All that sacrifice, based only on perception and expectation of being able to bring India on track of enviable economic growth. That is indeed a great sacrifice, as it reflects the mentality of average, mostly educated, Indian of today. He is ready to overlook (almost forgotten) the governments role in the pogrom that killed over 1000 of his fellow contrymen only a decade back, plus countless other miseries such as rapes, displacement, illegal appropriation of assets, and discrimination at work place, education institutes, and public offices of the minorities. He is ready to overlook the fact that: long term development, that is more meaningful and equitable, than just raw GDP data; it is necessary for the goverment to tackle issues that pose challenge to the 'capital investment' based model in its policy making, and respect the rights and concerns of other stakeholders than just the capitalist. Sidelining those concern and stakeholder, though can create jobs and growth in the short -run, it will eventually extract its price: by mainly rising social and ecnomic inequality, threat to internal national security and harmony and a unbalanced, unsustainable growth path that will engender anothet set of political issues to deal with down the line, as China has realized in the past 3-4 years.

Another trait of this elections campaign mania has been the ease with which the Indian voter (educated and otherwise) can be obfuscated with glizty marketing and branding ploys. Though there are millions of Indians to harp about Modi's economic miracle in Gujarat and his leadership (most of them confusing leaderhsip with autocracy) very few and I repeat indeed very few actually can articulate what those 'achievements' indeed are and still fewer have any idea of how they have been achieved. Not much doubting the depth of critical mindset of Indian voters, the BJP campaign machinery has gone the 'end of the world' in marketing Modi strength as the sole purpose of it being the rightful candidate to form the government at the center without devoting much time and energy in communicating What and How the Economic Growth implicty proffered to the voters in exchange of their votes will be achieved. Nor Mr. Modi has made any attempts to articulate what his vision for the country is, what issues does he intends to tacke and how? to re-ingite the India Shining story.

Although, I have to concede here that the last of the problems mentioned in the prior paragraph is across the Indian political landscape where candidates promises are more friction than facts. Very few, even those running for the highest posts, make any attempts to go into detail of their game plan for the country and how they intend to achieve it. Candidate never debate with one another on the same stage on issues vital for the country and how they intend to tackle it (maybe they too have no clue on that!). Mass rallies are similar in analogy to religious sermons where its sacreligious to ask questions and you have to use your emotions more than your head to believe that your candidate tells you. As much as 50% of the time is spend in only jibbing at and belittling the opponent on issues that are sensational rather than of national importance.

The Modi led BJP govt seems to be likely at the center after the May elections and that is what the polls suggest. It will be interesting to see what and how much Mr. Modi delivers when the rubber meets the road. I will endevour to update this article after the May election results outcome.