Fifteen years ago if a retail investor, even a giant one, needed to know a PE ratio they had to call their broker. In essence, this was the value proposition of the brokerage industry – they were the ones with the information investors needed, and charged accordingly. In many ways the advice business remains structured around this outdated concept despite its obsolescence, and Josh Brown has gone to great pains to explain why this is so.
The ubiquity of online data and opinion has completely reshaped investor requirements. The base facts are completely commoditized and what is now necessary is prioritization and context, someone to advise on which data points matter most at any given time. This thought formed the underpinning of most of the initiatives at my previous position – I spent less time attempting to reinvent the financial wheel and more in organizing available facts into plausible narratives. Importantly, I was doing this for everybody, which entailed that at any given time there were five or six often-contradictory scenarios to maintain. If I were just doing this for my PA, I could pick the most plausible projection and just follow that.
Which brings us to now. Whereas before I would add newly released data to existing spreadsheets tracking trend projections now there is so little truly important data available (i.e. CDS quotes) that attempting to cobble together a spreadsheet is not worth the time and effort. Furthermore, there are none of those quick chats with analysts to tease out the details unpublished in for research reports. (Analysts are constrained – not idiots. They know lots of stuff that can’t, or won’t print). I am, in effect, now an Outsider little different from diligent retail investors and this has changed my investment style completely. I’ve organized the general changes in methodology into three rules, which reflect my own experience and are not meant to be exhaustive:
Outsider Investor Rule 1: You need to have a view. There is no way, as an Outsider, to adequately follow even five or six potential market outlooks with enough depth to make their conclusions worth risking your cash. A flexible economic/market outlook makes the sorting process of new developments a binary operation – fits or does not fit. Investors without a plausible scenario in mind may feel more open-minded, but are also more likely to sell copper miners on a weak durable goods number and buy them back on stronger NFP. Without a view, in other words, new data is not organizable into a usable context for investment decisions.
None of this is to suggest blind adherence to an uncertain set of predictions. The “does not fit” column has to be maintained, if anything more diligently than the “does fit” to prevent losses.
Outsider Rule #2: Secular over Cyclical. Reducing economic sensitivity in a portfolio can drastically reduce portfolio risk and the labor involved in investment decisions. Investors in construction equipment, for instance, will be forced to white knuckle every dubious Chinese economic data report for the foreseeable future, three or four times per month. There are, however, investable trends that will happen, at varying speeds, regardless of the economy. The average age of the developed world population will rise in complete disregard to global industrial production levels. Mobile data transmission will increase by 100% or so for at least the next five years.
Investing in secular trends is not necessarily easier, but it does reduce the number of variables to be considered. Biotechnology companies, as a notable example of a counter-cyclical sector, are beset by competitive and regulatory pressures and are not guaranteed outsized returns. But, the same is true of cyclical companies to some extent and unlike them, the value of biotech stocks do not hop around by three or four percent every morning at 8:30. Orthopedic stocks, as another counter-cyclical case from health care, are inexplicably twitchy but there are few plausible scenarios under which demographic-based end demand will not provide a fertile backdrop. For cyclical sectors, a 1997-like growth hiccough in China would place an open manhole in front of shareholders.
The risk/return trade-off does dictate that investors following rule #2 to the letter are limiting potential returns generated by a global economic recovery. All portfolios should have some economic growth exposure, but the amount should be roughly inversely correlated to how much time is available for research and general obsessing over existing holdings.
Outsider Investor Rule #3: Know Your Limitations. The proliferation of ETFs has proven an effective tool to avoid specific company risk through diversification. In the end however, time-constrained Outsiders must consistently be aware that they do not have time to fully understand the whys and wherefores of their portfolio performance. Unexpected things, bad things, will happen that we never see coming. Conversely, we are likely to trail the index for significant periods of time because we “missed” something. Outsider psychological well being, I think, is dependent more on the acceptance of this fact than any other. To fight it is to open the door to a “headless chicken” investment style that is more likely to buy a yacht for your broker than yourself.
In Wall Street, Gekko reinforces the stereotypically aggressive, chest-thumping characteristics of finance by having Bud read “Art of War”. The book still comes comes up, although references are usually limited to the “manly men” strategies on how to destroy opponents. For Outsider investors, however, the best advice comes at the beginning:
It is said that if you know your enemies and know yourself, you will not be imperiled in a hundred battles; if you do not know your enemies but do know yourself, you will win one and lose one; if you do not know your enemies nor yourself, you will be imperiled in every single battle.
Or, to paraphrase another timeless classic: The first rule of Outsider is to recognize that you’re an Outsider.
Personal note: I’m getting very close to a new position, just awaiting a contract. Its an amazing initiative and, for those few people worried about it, should mean more available Interloper writing rather than less, although under my real name. If anyone’s seen an “Idiot’s Guide to Un-anonymizing Yourself” I’d appreciate it if they could point it out.