Sports metaphors are massively over-used but I want to preface this discussion of Legg Mason’s Bill Miller by stated unequivocally that when it’s all said and done, he deserves a lifetime slot in the money management Hall of Fame. To state otherwise is analogous to arguing that DiMaggio sucked because he hit .263 in his final year. In any event, it’s not important that you agree with me on this, I’m just stating my bias up front.
I met Miller once, as part of a small group. I studied my ass off ahead of time because I didn’t want to waste time asking him questions that were already part of public record – he was at his peak and was the subject of numerous interviews and profiles. Despite his success, the most interesting aspect of the meeting was a discussion of his, to that point, biggest mistake, Tyco. Miller was asked at what levels he was buying Tyco and we were all initially stunned when he bluntly responded “all the way down”.
I learned later the source of his confidence. Discussions with his analysts made clear that the stock selection methodology was ridiculously exhaustive, identifying up to 25 economic, micro or market factors that had historically affected the stock price. (They were aware, before you ask, that correlation is not causation and that the data applicability decisions were subjective). The scenario analysis estimated stock performance for every potential combination of changes in the factors – an insanely, exponentially complicated and detailed process.
In hindsight my biggest question surrounds why, if the model worked so well for so long, is it working considerably less well now. Undoubtedly, Miller and his team have identified specific indicators that are now far more or less powerful in determining stock price outcomes than a decade ago. There may, however, be a much larger issue at stake – the pre-GFC market may have rewarded those with the largest tolerance for risk whereas current conditions do not.
Buying Tyco “all the way down” to zero was an obvious mistake but we can safely assume that a 15- year track record of beating the S&P 500 featured a lot more cases when this process resulted in market-crushing returns. Buying Nextel all the way down to $3 for example, in 2003 was a much more positive experience for unitholders. Either way, it seems evident that managing money like this requires a tremendously high risk tolerance, a sustained belief that the market is wrong and that you are right and the conviction to stand in front of the runaway train until it slows down and the stock bottoms.*
We can argue about when it officially started, but there is no reasonable argument that can disprove that a credit bubble ended in 2008, three years after Miller’s streak ended. The highest investment returns in bubble environments, almost by definition, are generated by the highest beta or risk levels (the math is a virtual tautology in this regard). It is possible then, using Miller as the example, to infer that high risk tolerance was a significant determinant of performance in the pre-GFC world and, if we have commenced a new period of higher volatility and lower returns, that the characteristics of successful managers in the years ahead will be markedly different.
The big assumption in this argument is that credit conditions have fundamentally changed in the past three years, and that a period of slower growth and balance sheet deleveraging is on the horizon. Admittedly, higher-beta sectors like commodities have generally led rallies since March 2009, suggesting that risk-averse stock selection methods have not, and may not, assume performance leadership. It is, on the other hand, hard to imagine, even noting the notoriously short memories within the world of finance, that the confidence of investors has not declined over the past decade. No matter what happens, I would suggest that the general era of “bravest investor wins” has come to a close.
*It did not fit well into the body of the post, but it is important to note that Bill Miller’s portfolio did not and doesn’t consist solely of these high-risk type positions. There were also conventional Graham and Dodd value plays and also non-distressed, high valuation situations like Amazon and eBay. The “all the way down” situations did, however, garner the bulk of the media attention. I note also that Miller’s recent experience with Kodak fits the theme of this post.
VERY interesting Int. thank you for sharing.
What do you suppose would be the hallmark of successful investors today? I’m thinking something akin to “value investing” (but I hate to use that term). What I mean is that you’ll see investors outweigh their steady beta and fixed income plays with high probability risk/reward plays where they take profits at reasonable points, expecting a mean reversion sooner than later, at which point they can re-assess another play. I guess you could call it “guerrilla” investing if you wanted.
If breadth narrows up a lot, conservative growth strategies tend to work best.
[...] The “bravest investor wins” era is over. (Interloper) [...]
@Interloper,
Actually, if you believe the Caballero hypothesis, as I do, the problem is actually TOO LITTLE RISK taking across the entire economy. The Caballero hypothesis (according to Ricardo Caballero of MIT) is that there has been far too much wealth created in the last 30 years in comparison to the amount of “safe” or “safe-ish” financial assets in which that wealth can be parked. Thus, the incredible demand for seemingly high quality fixed income assets is what has ultimately fueled this crisis.
The only solution is to think like an owner when owning stocks, something virtually impossible to do as an intermediary, but very possible as an owner of capital. The intermediary’s (e.g. mutual funds, asset management, etc.) job has turned into high-stakes casino investing because they don’t have the ability to hold the way an owner would. So, they all are playing one variety or another of the beauty contest game against one another.
Your intuition and inference may be the correct one for individuals, but the emergent result will be a continuation of this debacle we’ve seen. The right “policy” would be for more people to be comfortable with being residual claimants for at least the medium term.
I can see that. Enough demand for safe-ish that CDOs slipped through serious analysis and then blew up.
That’s precisely right. The Caballero hypothesis explains why anything that could get 10 miles within a Triple A rating from any bozo was bound to be a huge hit.
“[I]f we have commenced a new period of higher volatility and lower returns….”
There is no doubt that day-to-day volatility is much higher. But for longer periods…not so much.
For the period 1927-1999, the annual standard deviation of the S&P 500 Index was 20.3 percent. From 2000 through 2010,it was 20.5 percent. The quarterly standard deviation of the S&P 500 prior to 2000 was 11.7 percent. Since then, it has been 9.0 percent. And prior to 2000, the monthly standard deviation was 5.7 percent. Since then it has been 4.7.
I’m not quite sure what that means (although I suspect that HFT is significant), but it’s interesting nonetheless.
that’s interesting and good stats. It actually makes sense that higher volatility would have a lower quarterly standard deviation b/c with volatility comes lots more mean reversion and with mean reversion comes alot of moving fast but going nowhere type of “noise” in the markets. On average we’ve been doing daily mean reversion for about 10 years now if you look at the S&P data I believe. That means higher volatility which results in us not really make yoy gains like the last bull market we saw since the 50′s or whatever and really the S&P charts reflect that as we are really just in a channel since 2000, etc. That channel should make for lower standard deviations particularly at the quarterly level I would think.
We’re now seeing investors starting to consider that in actual fact over the past 10 years if you just held Treasuries you’d actually be farther ahead than if you just held the S&P. The exact details on those stats escape me at this moment but that’s what I keep reading/hearing about lately.
Great post. Been thinking that maybe Long/Short spreads work well here. The rationale being that you eliminate the huge macro issues that will dog assets over the next 5-10 years and bet on management teams or specific situations. If returns do come down and riding beta (with some alpha generation) is no longer as attractive, there must surely still be incompetence to short. Maybe more so in this environment. In some cases, the volatility of the spread may actually be lower than both assets individually. Anybody have any thoughts?
http://www.cleananalyst.com
In any case, most of these motu’s played exclusively with opm, and kept their money in bullion or paper bags buried in the backyard.
They knew/know in their hearts its just a confidence game.
Good observation. With increased volatility and markets that are no longer trading with mostly a positive trend, leverage is a dangerous game, as we continue to see casualties virtually on a weekly basis.
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