Weekly Insider (Imagining Improbable & Friedman or Goldman)

In a recent National Geographic piece, Laurence Gonzales, author of the excellent “Deep Survival” wrote a piece describing the unfortunate and perhaps preventable death of an adventurer to an avalanche. Gonzales invokes a quote from Christopher Burney--a British commando captured and imprisoned at Buchenwald, the concentration camp, during WWII. Burney said: "Death is a word which presents no real target to the minds eye." Gonzales, turning our attention back to his fallen adventurer protagonist, says: “Death was a failure of imagination.”

And so it is in markets. Forget formulas, imagining the improbable. This is the absolute best form of risk management. Imagine what could go wrong and more importantly what the consequence of something going wrong is. Losing money: unpleasant but bearable depending on the magnitude. Losing your life: remember anything times zero is zero. I’ve written in the past, that the more we know (ie. the wider the area of our searchlight) the less we know (ie. the greater circumference of the dark unknown). It’s why complacency leaves to catastrophe. How comfort or ignorance of risk leads to failures. We compound the unknowns. It’s what lurks on the edges of that searchlight that might provide the greatest opportunity or the greatest risk. And it’s why so many things in life are so damn exciting.

Of course: today's disasters are tomorrow’s safeguards. Insurance, material safety data sheets (in chemistry labs), laws all came respectively from explosions, corrosions and corruptions.

So, what disasters loom? Start with what everyone takes as granted? What would take people by surprise? Will Gold, oil and every other commodity you can name continue their ascent? Is it more likely the Chindia demand narrative and gospel keeps people in the pews? Or do already high expectations and fewer incremental buyers on the margin mean vulnerability for surprise?  Why is their virtually no media coverage of the rise in Oil as primarily a function of dollar decline and speculation? Over time, commodities approach their marginal cost of extraction. And being commodities: they’re undifferentiated and compete on price. When have VCs ever in history made money chasing ways to produce a commodity? Why do people keep insisting that solar is attractive when Oil is at $100 when we barely produce any electricity from oil? 50 years ago, sure—but oil is a declining piece of our energy pie as more and more things become electrified. What effect would an “unexpected” decline in commodity prices have on emerging markets? I’ll return to this in a moment.

Meanwhile, James Montier of Societe General (not the rogue trader) recently pointed out a few must note statistics: Some of the prediction markets like Intrade put current odds of a recession at 65%. The S&P 500 P/Es are about where they were in 1929—not cheap. US earnings haven't historically grown during a full cycle (ie. peak-to-peak or trough-to-trough) more than 6%. And as Jeremy Grantham will tell you: profit margins are the most mean-reverting sequence in all finance, or else capitalism is broken. Large caps are more liquid than small caps yet are trading at a discount to them, which means small caps basically have a liquidity premium that is negative.

The same thing holds for emerging markets. Given their higher risk and uncertainty they’ve historically traded at discount. Not so today. And as I note above: gold, oil, copper and the commodity cabals are all currently through the roof. But the roof of housing has caved in. Commercial real estate appears to be next. Demand slows. Prices fall. And if prices fall, then those emerging markets so heavily dependent on the outrageous prices for commodities (benefiting the owners of capital, yet crippling the population) will begin losing money. As they say of emerging markets: it’s where emergencies emerge. All the same people claiming “decoupling” were claiming “globalization” before. You can’t have both. You must choose: Friedman or Goldman (ie. Thomas Friedman (the world is flat) or Goldman Sachs, which started the “decoupling” meme).

Countless friends at hedge funds lamented to me how horrible January was. Cash levels at mutual funds are at all time lows and so are average holding periods at around nine months. Meanwhile, empirical studies have shown two very interesting things about short holding periods. The first: the shorter you hold the worse the returns. The second: the shorter you hold--the more any gains are likely to result from randomness, noise and luck rather then skill. Those focused on monthly or quarterly performance and a short investment duration--that matches the liquidity demands of investor redemption durations --have to do something. Idle hands are the devils workshop. A devil of our own design, as Rick Bookstaber might say. Or as Blaise Pascal might say, all human evil comes from a single cause, man's inability to sit still in a room. Sometimes inaction is the best action.

Meanwhile all the people chasing growth are chasing high-tech flyers and solar stocks at any price with little attention to value. Remember price is what you pay and value is what you get. The implied expectations reflected by current prices calls for 40%+ annual growth for more than 10 years--no company grows that much for that long. That’s doubling less than every 2 years. The other growth area as I noted before are commodity and mining players who are and have always been cylicals. That means cycles! Like Newton: what goes up must (eventually) come down. These are high expectations and high expectations mean big reactions to disappointments.

Consider this: go see “There Will Be Blood”. Believe me when I say it’s the absolute best movie you can and will ever see in your life--the cinematography, the script, the acting, the music, the wardrobe. Now believe me when I say you shouldn’t believe what I just said. I don't really believe it’s the best movie ever, though it’s a fair way to enjoy two hours of your roughly 683, 280 hours of life—or 9,000 thumps of your roughly allocated 2.8 billion heartbeats. My point is this: high expectations can make things worse when actually experienced. And never was this truer than in markets.

A few years ago, I wrote this:

“Friends married this past weekend outside of Rome offering a chance to recharge amongst the juxtapositions of antiquity and modernity. A crypt affixed to an old church held the meticulous and macabre skeletal remains of capuchin monks. Their eerie truth etched and echoed “Quello che voi siete no eravamo quello che noi siamo voi sarete" which translates to: What you are now, we once were; what we are now, you will be.

I often write about (and less often adhere to) emotion and reason, specifically to be an abolitionist given Humes’ decree that reason is a slave to emotion. Roman ruler Marcus Aurelius noted nearly 1,000 years ago, “If you are distressed by anything external, the pain is not due to the thing itself, but to your estimate of it; and this you have the power to revoke at any moment”. Or as Aesop said, “It is with our passions, as it is with fire and water, they are good servants but bad masters.” Emotions respond first. So, having a strong backup system of calculated rational thought is essential.

            My flight home reminded me of the importance of backup systems. If you’re flying on an airplane with a cockpit control system that’s got a 99% success rate, which is backed up by another system that has a 90% success rate, it will fail only 0.1% of the time. But if you’re on a flight where the plane requires both systems, its going to fall 11% of the time. The latter being 1,000 times more dangerous than the former.

The same thing goes for companies. As an investor we build a portfolio. The diversification is one backup system. The individual company having management that can adapt to a changing environment (or a faltering technology or product) is yet another backup system. Remember Darwin didn’t point to the survival of the fittest but to the survival of the most adaptable. A platform company with a multitude of real options (and real optionality) is yet another. Read: In case of emergency, break course fast. Price is yet another backup system. The lower it is relative to assessed intrinsic value, the higher margin of safety you have if your analysis proves wrong. You don’t want to diversify away your opportunity, but having backup systems and contingency plans give you several ways to win. Being fully integrated with all eggs in one basket gives you several ways to lose.

And remember if you’re sitting in the same theatre as everyone else, nodding along to the same sermon—when there’s a rush for the exit—everyone is thinking they’ll get out before you. Like the joke of the bear chasing the two hunters, when one tells the other, “Stop running, you’ll never outrun him.” The other replies, “I don’t need to outrun him—just you!”