“Seemingly logical, but as I’ve pointed out in recent years – not working very well because zero and negative interest rates break down capitalistic business models related to banking, insurance, pension funds, and ultimately small savers. They can’t earn anything!”
“The unintended increase in the demand for physical cash caused by negative rates can lead to adverse economic effects. When agents want to hold more cash, the velocity of money drops, the money multiplier no longer works: policies designed to create inflation feed deflation.”
My 18-year-old son, Matthew, came to me asking about how the economy works. This summer he will be an intern and task one prior to his start date is to read “How the Economic Machine Works.” There is much we can learn from history and it makes sense to study the research from some of the brightest amongst us. From there, he and I will begin a dialogue.
This past week I watched CNN’s Fareed Zakaria interview former Federal Reserve Chairmen Paul Volker, Alan Greenspan and Ben Bernanke and current Chair Janet Yellen. The interview concentrated on how the Fed makes decisions on interest rates. You can watch the interview here (jump forward 16 minutes for the start). Following are several of their individual comments.
We are facing risks like what we’ve seen globally, productivity growth is only modest, which is also a problem but the domestic U.S. economy is moving forward
I don’t see any particular reason why a recession is any more likely in 2016 than it was in 2015 or 2014
That being said, it is true that if recession were to start, the Fed is starting from a lower level of interest rates than would normally be the case, so the extent to which the Fed could cut is less
His reaction to that is that there other tools, such as forward guidance and QE. We are seeing experiments globally, so there are other tools that we can use. The Fed is not out of ammunition.
However, we have learned that it is a mistake to put all of the burden on central bank monetary policy. What is needed is a more balanced policy (such as structural reform and fiscal policy from government), which would no doubt work even if the central bank is forced to the limit
I think the major problem that exists is productivity growth across the spectrum of all countries has been below 1% over the last five years. How do we create a GDP growth rate (output per hour times the expansion in the labor force)
He believes it is that capital investment, pretty much everywhere, has slowed down to a significant extent and, as a percentage of GDP, has been dramatically lower than where it has been historically
The data importantly show that what we are facing with the demographics we have is an expansion of debt. Unless and until we address this issue, we are going to have problems that are not going to get resolved.
There is a lot of reliance on very short-term borrowing to make illiquid investments, a large part of it in the financial sector, without contribution to productivity or real investment is increasing risks in the economy
Fareed asks Bernanke how the Fed will unwind the $4.5 trillion dollars of QE assets it has bought since the Great Recession. Bernanke said:
“In terms of the unwinding, it is a straight-forward process and the Fed has been very clear, at some point the Fed will simply stop reinvesting securities as they mature and let them roll off as they mature and over a period of a number of years it will just go down.”
In the end, all we have to show for it, besides the fact that they (NIRP, QE, messaging) have helped our economy recover, the Fed has sent profits to the Treasury of $500 billion which has reduced the burden on the taxpayer.
It has been on the whole a pretty successful policy and I don’t think the roll out (unwinding of the assets on the Fed’s balance sheet) will be problematic.
Reread that bold section. It will be interesting explaining that one to Matthew. You can listen to the entire interview and I believe it is worth your time, but I’d like to add that we are dealing with highly complex systems that involve billions of moving parts. To this end, I liked what Greenspan said towards the end of the interview.
Specifically Greenspan said, “Monetary [policy] is largely economic forecasting and our ability to forecast is significantly limited and we have to keep the context of what we say in the context of what we know and this is a very serious problem that has always existed [for the Fed]. So how do you convey what you know and what is clear without going beyond into the area of forecasting beyond our knowledge?”
What I think I heard him say was, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” Quoting Friedrich Hayek of Nobel Prize in Economics fame.
These tools may both help and hurt. If the Fed can pull off a soft landing, they can’t do it alone. The fiscal side of the equation involves help from those that can create the structural lift. You know, the guys and gals we are all disgusted with in D.C.
To get to what Ray Dalio calls “the beautiful deleveraging” will require all of the components of the orchestra working together. Right now the brass section won’t work with the string section and the conductor is doing all she can do to make the music sound good. There has been a great deal of experimentation.
The business cycle is the fluctuation in economic activity that an economy experiences over a period of time. A business cycle is basically defined in terms of periods of expansion or recession.
During expansions, the economy is growing in real terms (excluding inflation), as evidenced by increases in indicators such as employment, industrial production, sales and personal incomes. During recessions, the economy is contracting, as measured by decreases in the above indicators.
Expansion is measured from the trough (or bottom) of the previous business cycle to the peak of the current cycle, while recession is measured from the peak to the trough. In the United States, the National Bureau of Economic Research (NBER) determines the official dates for business cycles.
According to NBER, there have been 11 business cycles from 1945 to 2009, with the average length of a cycle lasting about 69 months, or a little less than six years. The average expansion during this period has lasted 58.4 months, while the average contraction has lasted only 11.1 months.
The last expansion was determined to have commenced in June 2009, the period when the Great Recession of 2007-09 reached its trough (technically, that recession began in December 2007). (Source: Investopedia.)
Since this current cycle is aged and statistically due for recession, in makes sense for us to pay attention. Below you’ll find my favorite recession watch indicators. Jumping to the conclusion: there remains a high probability of a global recession and no signs of a U.S. recession just yet.
But before we do, I’m going to see if I can get permission to share an awesome research piece from Tim Hayes at Ned Davis Research. In the piece, Tim summarizes what boiled in the back of my mind as I watched the CNN Fed interview.
“In the Road to Serfdom, Friedrich Von Hayek ultimately anchors his libertarian philosophy on the realization that our knowledge of complex social systems is extremely limited. For Hayek, every economist should start by reflecting on how little he understands, before building complex models to “predict” economic behavior.
Hayek’s modest admission echoes the Delphic injunction: “scio me nihil scire” (I know that I know nothing). A light-handed approach to policy-making stems from the admission of our limited forecasting abilities.
In medicine, doctors do not treat conditions that they do not understand: observation should precede actions. The “primum non nocere” (first do no harm) principle of the Hippocratic Oath reminds every medicine student that every action comes with unintended consequences.
Modern central banking seems to have turned the Hippocratic Oath on its head: “act first, think later” seems to be the motto du jour. If policies do not have their intended effects, it must be because they have not been pursued vigorously enough, and doses should be doubled.”
Improvable statements can always be used to silence critics: as M. Draghi said on Thursday, “We can demonstrate that the growth of the economy was higher than it would have been if we had not taken those measures” (author’s note: how? By re-creating an alternative universe without NIRP?).
Ok, grab that coffee and take a quick run through the recession charts. The world isn’t going to fall apart and just as we moved through the last two recessions and the near collapse of the financial system in 2008, we’ll all be ok. The objective is to make sure we do it with our wealth intact.
I share data from Doug Short on the historical performance of the S&P 500 during recessions (note the challenges when valuations are high – and they are high today). If you are a long-time reader, you’ve seen this chart before. Still worth another look, I think.
GDP Annual Growth Rate in the United States averaged 3.22 percent from 1948 until 2015, reaching an all-time high of 13.40 percent in the fourth quarter of 1950 and a record low of -4.10 percent in the second quarter of 2009.
Excessive debt is the drag. See Reinhart and Rogoff – This Time is Different: A Panoramic View of Eight Centuries of Financial Crisis and How The Economic Machine Works.
I believe we are in a debt deleveraging cycle that occurs once in a generation. I don’t believe the Fed is factoring this into their models.
If you click on the link embedded in the chart, you can separately look at a number of the countries around the world. In the developed world, the U.S. looks good by comparison. Yet most everywhere, debt remains a drag on GDP.
Within the NFIB monthly economic trends report is the following statement, “A ‘chartist’ looking at the data historically might conclude that the Index has clearly hit a top and is flashing a recession signal. The April survey will decide whether or not the alarm should be rung. This month’s change was not statistically significant, just not in a positive direction.”
Bespoke Investment Group summed it up this way, “The above line from this month’s NFIB monthly economic trends report doesn’t pull any punches regarding the state of sentiment among small businesses in the US. The NFIB’s overall index of small business optimism has declined for three straight months, extending what has been its largest peak-to-trough decline of the current economic expansion, and taking the index down to its lowest level since February 2014. Not only has the headline index declined for three straight months, but it has also missed expectations in each of those months.”
But profits are not looking very good (this next chart is signaling economic contraction due to a fall in profits of greater than 24%):
One of the historically best predictors of recession is an “inverted yield curve” (that is when short-term interest rates are higher than long term interest rates):
Here is a look at the current yield curve (note how long-term rates are high – signaling no recession):
Next is a look at the real yield curve (adjusted for inflation). Note that long-term real rates are higher than short-term rates, so no recession signal here:
This following section is from DShort.com. It looks at valuation and then ranks it compared to historical levels. What I really like is how he shows that risk is highest when valuations are the greatest, especially during periods of recession.
Note: In response to an email, I’ve updated the data in this article through the March month-end numbers and at the launch of the Q1 2016 earnings season.
When I initiated the dshort web page in late 2005, one of my routine topics was equity valuations, initially inspired by Nobel laureate Robert Shiller’s book, Irrational Exuberance, the second edition of which was published earlier that year. I gradually expanded my focus from his cyclically adjusted price-to-earnings ratio (CAPE) to include Ed Easterling’s Crestmont P/E, Nobel laureate James Tobin’s Q Ratio and my own monthly regression analysis of the S&P 500. A few years ago I began posting a monthly update featuring an overlay of the four. Here is a chart that shows the average of the four valuation indicators from a geometric mean regression.
Last year I had a fascinating conversation with Neile Wolfe, of Wells Fargo Advisors, LLC. Based on the underlying data in the chart above, Neile made some cogent observations about the historical relationships between equity valuations, recessions and market prices: High valuations lead to large stock market declines during recessions. During secular bull markets, modest overvaluation does not produce large stock market declines. During secular bear markets, modest overvaluation still produces large stock market declines. Here is a table that highlights some of the key points. The rows are sorted by the valuation column.
Beginning with the market peak before the epic Crash of 1929, there have been fourteen recessions as defined by the National Bureau of Economic Research (NBER). The table above lists the recessions, the recession lengths, the valuation (as documented in the chart illustration above), the peak-to-trough changes in market price and GDP. The market price is based on the S&P Composite, an academic splicing of the S&P 500, which dates from 1957 and the S&P 90 for the earlier years (more on that splice here). I’ve included a row for our current valuation, through the end of March, to assist us in making an assessment of potential risk of a near-term recession. The valuation that preceded the Tech Bubble tops the list and was associated with a 49.1% decline in the S&P 500. The largest decline, of course, was associated with the 43-month recession that began in 1929. Note: Our current market valuation puts us between the two. Here’s an interesting calculation not included in the table: Of the nine market declines associated with recessions that started with valuations above the mean, the average decline was -42.8%. Of the four declines that began with valuations below the mean, the average was -19.9% (and that doesn’t factor in the 1945 outlier recession associated with a market gain). What are the Implications of Overvaluation for Portfolio Management?
Neile and I discussed his thoughts on the data in this table with respect to portfolio management. I came away with some key implications: The S&P 500 is likely to decline severely during the next recession, and future index returns over the next 7 to 10 years are likely to be low. Given this scenario, over the next 7 to 10 years a buy and hold strategy may not meet the return assumptions that many investors have for their portfolio. Asset allocation in general and tactical asset allocation specifically are going to be THE important determinant of portfolio return during this time frame. Just buying and holding the S&P 500 is likely be disappointing. Some market commentators argue that high long-term valuations (e.g., Shiller’s CAPE) no longer matter because accounting standards have changed and the stock market is still going up. However, the impact of elevated valuations — when it really matters — is expressed when the business cycle peaks and the next recession rolls around. Elevated valuations do not take a toll on portfolios so long as the economy is in expansion.
As I mentioned in last week’s “A Powerful and Reliable Determinant of Long-Term Investment Returns”, Wall Street analysts are estimating a 10% decline in earnings in Q1. Should the market remain elevated, expect even higher valuation levels over the next few months.
Negative interest rate policy, or NIRP, is the most recently deployed weapon of central bankers in their long campaign of financial repression—a deliberate policy of depressing interest rates in order to transfer wealth from savers (private citizens) to debtors (largely governments). Financial repression is intended to improve near-term growth by encouraging consumption and discouraging savings. Why save today if your money will purchase less tomorrow?
The article discusses how investors may wish to alter their investment plans to take account of the changes in expected returns both within and across capital markets given the new NIRP environment.
Investors are wise to be concerned by zero and negative interest rate policies promulgated by central bankers, because starting yields predict future investment returns. Zero real interest rates predict zero real returns, and negative real interest rates predict negative real returns.
For long-term investors, risk is more about failing to meet wealth accumulation goals than about short-term changes in the price of their portfolios; thus, the more appropriate measure of risk is the estimated probability of reaching or failing to reach the desired or needed long-term real return level.
Given the new NIRP environment, investors may wish to look beyond a traditional 60/40 portfolio to a portfolio holding substantial allocations in non-U.S. equities, alternatives, and credit.
Relative Strength Leadership Trends: The portfolio is approximately 36% fixed income and 64% equities. On the equity front, we see the strongest relative strength price leadership in REITs, materials, utilities, telecommunications, information technology and emerging markets. Fixed income positions include muni bonds, intermediate term corporates, international fixed income and long-term U.S. Treasuries.
This strategy is a relative strength-driven process that evaluates the price momentum of approximately 100 different ETFs, including large-caps, mid-caps, small-caps, value and growth, sectors, various fixed income, international and emerging markets. Up to 11 positions are held.
ZIRP (zero interest rate policy) and NIRP (negative interest rate policy) has created a hunger for yield and a perceived need to take on more risk. How does the retiree or pre-retiree grow wealth? How will pensions achieve their 7.5% actuarial return targets in a world of 1.75% 10-year Treasuries and equity forward-return probabilities of 2% to 4% (due to current high valuations)? This in a 2% growth world. New normal to new crisis.
“Households save to generate a given level of wealth at retirement: when rates fall, they need more savings to achieve the same targets. In other words, lower rates beget higher savings, which in turn reduces economic demand, which then lead central bankers to cut rates further to “stimulate the economy”. Central bankers have come full circle, and the monetary snake is eating its own tail.” Again from NDR’s Tim Hayes. Well said.
Our high-yield trend model is back in a buy. It’s been a pretty good run. We see risk on in our tactical relative strength models. That emerging market buy last month raised my eye brow but so far that has been a good move. Hedge that equity and include some systematic processes that can help you broadly diversify your exposures.
I’m in NYC again on April 20, 21 and 26. May trips to Chicago followed by John Mauldin’s Dallas Conference May 24-27. Back to Denver in mid-June for meetings. I’ll be speaking at the June Global Indexing and ETF Conference in Dana Point, California.
Greenwood Investors letter to investors for the third quarter ended September 30, 2017; titled, “The Other Side Of The Trade.”
We had another good quarter of performance, +8.0% for the Traditional composite and +8.1% for the Global Micro composite. More importantly, we have delivered on our purpose to maintain a highly actionable and attractive current portfolio. We have actively managed our book of investments, and when combined with solid strategic improvements at several of the underlying holdings, we have been able to maintain a very attractive opportunity set. At quarter-end, our portfolio carried over 40 units of potential upside for every unit of risk we have taken, and because we took advantage of market weakness in MEI Pharma (MEIP) subsequent to the quarter, this opportunity set has only improved in the past couple of weeks to a record for the year.
As discussed in last quarter’s letter, short-term investment performance is often attributed to us having a
differentiated and contrarian view on reality that turns out to be more accurate than that of our counterparties. In the long-term, builders, creators, and managers are actually the only ones who create value. Investors’ gains or losses are made at the expense of their counterparties’ gains or lost opportunities. Very few actually create value.
Through the diligence process, one of the most useful questions we continuously ask ourselves, is “who is on the other side of this trade, and what do they think?” One of the most convenient consequences of transparently sharing our thesis on our investments is the feedback this elicits, most usefully from those who don’t share a similar view of reality. While each person interprets information slightly differently than others, armed with extensive research on each situation, we seek to have the view most aligned with reality. We particularly look for situations where our view differs materially from that of the marginal or average counterparty. Of course, in a marketplace of millions of traders, this counterparty view is actually impossible to understand with any degree of precision.
But asking the question and exploring the other side of the trade is an incredibly useful part of the investment process, and we’d like to expand upon this diligence item in this quarterly letter. Also, because the other side of the trade in America is increasingly robotic, our counterparties are increasingly changing with interesting implications for investing going forward.
We recently wrote about our two favorite family-controlled companies where managers make decisions for the medium and long-term health of their businesses and legacies, often at the expense of immediate gratification. The short-term focused counterparties to our purchases in EXOR (EXO IM) and Bolloré (BOL FP) are myopically focused on the daily movements in the short-term Net Asset Value (NAV) and the historical discounts with which these securities have typically traded. In most cases, these counterparties are also expressing views on the underlying investments. EXOR has been most recently shunned because of the particularly active hurricane season this year. In one of the worst years on record, EXOR’s wholly-owned reinsurance company, PartnerRe (PRE) only incurred around 0.4% of the industry’s losses, despite having over 2.4% market share within the non-life reinsurance industry. Pricing for insurance contracts and reinsurance contracts are already strengthening in the aftermath of an epic year, one in which insured losses could easily surpass the 2005 insured losses of $117 billion. That was the worst year on record for the insurance industry. While this hurricane season will take 1-1.5% away from PRE’s book value (32-48 bps of
EXOR’s NAV), it will create the first constructive environment for the industry in a long while. As traders reacted to the news-flow by pushing EXOR’s discount to NAV deeper into value territory, we were taking advantage of the retreat by adding to the position for new clients. Through the excellent risk mitigation and management PartnerRe has routinely exhibited, plus the improving reinsurance environment, the market’s focus on bad news flow has allowed us to continue building a position in a compound interest machine at our counterparties’ lost opportunity. In just a few months, should the discount hold at such attractive levels, the company itself will be joining us on the buy-side of the market. So we are in very good company.
Similar to EXOR, our counterparties in the market for Bolloré demand a 61% discount to fair net asset value “because it’s always been that way.” With a more cash-rich balance sheet in the wake of the take-out of Havas by Vivendi, we wouldn’t be surprised if Bolloré wasn’t already joining us on the bid-side of the market. We know of no better investments for these companies than their own shares. The incremental bird-in-hand return on capital for each euro deployed on such repurchases is 48% for EXOR and 158% for Bolloré. We sincerely hope the discounts remain at their historically attractive levels, and trust our counterparties will keep them steady for the time being.
A recently added core position, TripAdvisor (TRIP), is particularly controversial, with a short interest at almost 20% of the float, or over eight days of liquidity. Online travel stocks have historically been crowded and expensive, given the phenomenal performance of shares of Priceline Group over the last decade, and the very strong performance of Expedia and Ctrip.com. But because the near-term visibility to TripAdvisor’s quarterly earnings is lower than normal, given it is in the midst of a transition in its marketing strategy, most of the investor base that would typically own TripAdvisor has flipped the long into a short. The typical counterparty in technology stocks is a fund that manages very short-term-focused limited partners, and a stock with 2.4x the market’s volatility and with low quarterly earnings predictability has forced much of the investor base to abandon this highly valuable asset. We think it’s created a situation with an exceptional risk-reward, as the company will likely be sold should its medium-term performance not continue to improve. Of course we would rather the results to continue the solid progress made in the first half of 2017, which would allow this to become a long-term core position for us. If not, we stand prepared to make the position significantly larger with any further weakness.
While Rolls-Royce (RR/ LN) has become less controversial than when we first built this core position, most sell-side analysts still rate the company as a short or hold. The marginal trade in Rolls-Royce is highly concerned with when the company will hit its £1 billion free-cash-flow (FCF) target. The company’s highly capable CEO Warren East, who has a history of being very conservative, has said that this could be achievable in the next few years. But as the company emerges from its “perfect storm,” during which it invested heavily in market share gains by delivering new loss-making engines in the midst of a weak environment for its profitable engines, it is slowly transitioning to a period where not only its engines will be profitable, but the revenue mix will be more skewed to extremely high-margin services business. The right question, if you ask us, is not trying to precisely time the company hitting the £1 billion FCF goal, but how quickly it can double that (we estimate about three years after the first milestone is hit). We are positioned to benefit from conservative 2018 guidance along with an accounting transition, and would like to rebuild Rolls-Royce to an over 10% position with incremental weakness. As FCF continues improving throughout 2018 and into 2019, we wouldn’t be surprised if Rolls joins us on the bid side of the market eventually.
Rounding out our top five positions, which make up more than half the portfolio, Telecom Italia (TITR IM) has been the king of “headline risk,” over the past year. Our counterparties are selling more shares to us because the government has been using nearly every avenue possible to get the company to agree to sell it portions or all of the company’s fixed-line network infrastructure. The state views this as a key asset of high strategic importance and it has exercised its “golden share,” right to have veto power over any asset sales of the company. We think the harder the government tries to acquire control of the network, the better this will turn out for shareholders of Telecom Italia. If the company separates its network, it will do so under highly accretive terms to current shareholders. Furthermore, this separation would demote the strategic importance of the standalone TI to the government, which would enable more interesting joint ventures with other media and telecom businesses in Europe. Thus, while our counterparties routinely devalue Telecom Italia’s stock with every news development related to the network separation, the headline-focused traders are increasingly missing the forest for the trees. We not only are welcoming of the network separation, but are urging Vivendi to embrace this split.
The Italian stock market often behaves very similarly to small cap US stocks, where rumors and news flow drive pronounced stock price movements. This gives fundamental investors, armed with detailed knowledge of the valuedrivers of a business, ample opportunity to let reason dominate emotion and take advantage of the irrationality. We have been equally perplexed by positive news-flow at MEI Pharma negatively affecting shares in recent months. We are quite happy about the weakness, and have returned the position to a top position for us. Investors trading on news flow, rumors and technical chart patterns would do well to realize that in a casino, the house almost always wins. We’ll be on the “house,” side of the transaction, and are happy to provide liquidity to these reacting traders.
Broadband adoption isn’t the only area where Italy is lagging America by at least a decade. Its stock market, along with most other European countries, has yet to become heavily robotized. Robotization of the U.S. market, which has been accelerating in recent years, removes the emotions from trading activity, but also adds momentum to stock prices. Often times, a robotized market either under-reacts or over-reacts to changes in the fundamentals of a company. Stocks that are included in index funds are routinely under-reacting to news-flow, while stocks outside of these all-important indices are seeing machines amplify the reactions of the few humans left in the market.
Furthermore, quantitative funds run by algorithms can only make decisions based upon analysis of recent historical trends. And although Silicon Valley is trying to invent the modern equivalent of the crystal ball, it has yet to make any substantive progress on quantum computers. While the crystal ball has remained elusive for Silicon Valley, it hasn’t stopped unicorns from becoming all the rage. Not only do we expect this ebullience to be the next financial bubble to burst (more on that in an article later this fall), but investors in these endeavors would have done well to consider their counterparties in such ventures. Almost always, the counterparty for new investors in such firms is typically the founder or the company. These counterparties have an inherent information advantage. We would rather be on the same side of the trade as a founder.
The other area of wide-spread financial ebullience, the bond market, has a similar trade imbalance. Sellers of credit are technically the management teams and companies that issue the securities, with a structural information advantage. The other side of the trade in the bond market is almost always someone who has outsourced pricing decisions to Moody’s and S&P. We all know how well that turned out a decade ago with mortgage-backed securities.
Studying counterparties and their motives is always a useful question a buyer should be asking in any transaction - be it a house, investment or even a consumable. And as we’ve mentioned, in the U.S. stock market, this counterparty is increasingly becoming robotized. This is forcing investors to consider how they will maintain an edge against computing power that can instantly process data and react far more quickly. We sarcastically call this exploration the “defense against the dark arts,” as automation and robotization will be affecting nearly every industry.
Today is an age of near-free and ubiquitous information. This information is increasingly getting processed and digested by machines who are simultaneously making buy-sell decisions based on an algorithm that is anchored on historical patterns. Yet, without the invention of the computerized crystal ball, these machines still cannot accurately paint a picture of future potentiality and cannot focus beyond the next few seconds.
In the most famous and successful example of machine-enabled fund management, Bridgewater Associates talks about the world as a mechanistic and predictable Rube Goldberg, to which computers can predictably and precisely react, given a properly-written algorithm based on the law of cause and effect. As quantum mechanics has long proved, causality, while useful to scientists centuries ago, is far too simplistic to accurately explain reality. Perhaps it worked to describe an apple falling from a tree, but it cannot accurately describe complex systems. Newtonian physics was so consistent in failing to explain actual observed experiments, an entire new field of science had to be invented to explain the actual outcomes of these experiments. The real world has an infinite range of possibilities and potentialities, and the probabilities of anything materializing are dynamically changing with every action and reaction.
Furthermore, the more variables one adds to a study, the less knowable the outcome of a range of potentialities becomes. The Heisenberg Uncertainty Principle actually proved that nothing can be measured with any degree of exactness if two or more variables exert influence upon the subject under investigation. Believing that we can draw precise conclusions about the economy and market defies science. This is important because precision, or the illusion of precision, is necessary for computers to draw reliable conclusions. Computers cannot make imprecise judgements about reality nor make actionable predictions based on incomplete information, though the industry tries.
One of Robert F. Kennedy’s campaign slogans was “Some men see things as they are and say, why; I dream things that never were and say, why not.” If he would have been an investor in 2017, perhaps he would have said something more along the lines of “Some machines see things as they are and say, trade; I dream of things that never were and say, I disagree.” Creative and strategic thought is inherently human. We’re not sure a machine will ever know how to, on its own, react to a turnaround plan, strategic operational changes, or a shift in the competitive dynamic of the industry. Some of our best investments have historically had the quantitative backward-looking appearance of a stagnant or deteriorating enterprise. Yet quantitative analysis can only get one so far. One must go beyond historical financials and study the myriad of influences that will affect the future trajectory of the company. We have summarized this evolving myriad as a quality score, and we have changed our portfolio display for the first time since inception to show this as the Y-axis in exhibit 2. We believe these qualitative factors, not inherently unpredictable catalysts, drive long-term company performance. We seek to maximize these drivers as well as the risk-reward for every position, among a few other key measures. It is our own “defense against the dark arts.”
But we’re not stopping there. We have remained relatively quiet over the last couple of months working nonstop on our next innovations. They will continue to further humanize and upgrade the investment process, and we are incredibly grateful to you, our investors, for giving us the privilege of investing and innovating on your behalf.