Recently, I have been trying to draft a post on my views about investment in general and the difference between theory and practice. In particular, I have wanted to examine the ideas and processes behind certain approaches to investing.
I am a great believer in process and preparation as a major determining factor in outcomes. With investment I have found applying this principle to be even more complex as your processes often rest on some core set of beliefs and ideas (even if you aren’t fully aware of this happening). In the past month or so my outcomes have suffered massively and I discovered (in the worst possible way) that some of the beliefs were lacking in any practical utility. The solution, I hope, is to write more fully on the portfolio and some of the ideas holding it together and problems I have been facing.
The core implication of this change is that there is a big difference between value investing in practice and in theory. I will also be phasing out the weekly reviews on the “Portfolio section” although I will keep posting the weekly return in basis points so I keep remembering to do the monthly reviews. I actually intended to start this last week so the next monthly review will be in three weeks.
From the table above the basic picture is that as the market has turned down I took a lot of risk off the table very quickly in non-core positions (Overall exposure actually increased though, something that I will explain later). So far this has been effective and since inception the portfolio has outperformed the market by over 600bps. Looking more closely though I think there is cause for concern as only two positions out of the 15 or so are actually in positive territory. Also, the knowledge that I have only lost 50% when everyone else has lost 60% isn’t a great comfort to me either. However, I think the majority of my faults can be summed up in one position: Aeropostale.
The chart above is the closing price of Aeropostale’s stock since I bought for the portfolio (I actually bought at $27 in the portfolio to match the price I first reviewed it at) and it is quite astonishing that I bought at the absolute high. My problem here wasn’t that I made a mistake in the actual valuation “process” but I completely misread the macro situation. What is more unfortunate is that I was aware of the risks in the macro situation but, quite frankly, I didn’t attach them to the micro situation with this company.
I think a major question with valuation is what is the person valuing the company contributing? Are they just saying this stock is cheap or are they saying this is why the stock will go up? Although I was aware of the differences between these two points (the portfolio used to be segregated on this difference) I definitely didn’t apply this to my investing in the right way. What I am getting at here is that the investor must have a clear grasp on the macro situation. This doesn’t mean to say that we need to forecast but we need to recognize the risks inherent in the economic situation and perhaps, more controversially, what investors think about the risks in the macro situation. Aeropostale was cheap when I bought and is still cheap now but the business although fundamentally strong is built on sand and, in practice, the investment proved to be nothing more than a levered bet on economic recovery. Failing to recognize that these were the risks of this investment was my main mistake.
So applying this logic to where we are now I have made two big changes to the portfolio. First, I have introduced some, frankly, very “un-value” positions. The first is a position in British American Tobacco. The thinking is that this is a good way to get market exposure to a well-run company (I have looked at this company a few times before) with relatively low macro exposure. I think BATS will attract a safe haven premium through the rest of this year as the macro situation (although promising in the long run) will worsen somewhat. The second is, far more controversially, a position in BH Macro Ltd. A closed-end investment trust invested in shares of Brevan Howard Master Fund. Brevan Howard is, in my opinion, the world’s leading global macro hedge fund and, through this period, I don’t think there will be many better places to invest money and, in particular, no better way to hedge off any beta exposure.
The second change, as mentioned earlier, is the concentration towards my more high conviction stocks. However, what I mean is concentrating cash in stocks where price will be driven by something outside of the normal economic cycle as in RWD, DCG or DWHA. Whilst I did, unfortunately, have conviction with Aeropostale I should have recognized that the outcome would, ultimately, be decided by something I couldn’t see in the financial statements. I have also closed out the investment in Diana Shipping. Whilst Diana is an extremely well run company, I don’t see the macro situation improving for it and ultimately the only way to make money with Diana is timing the shipping cycle well.
Finally, I am also going to move towards more liquid stocks. There is obviously the concern with stocks like Dewhurst, Lees Foods and Turbotec that we aren’t going to see a move towards “fair value” as they are just too small for most investors to be concerned with. So whilst its fine to allocate some money to these positions it makes sense not to allocate too much here as the forces pulling price back to “fair value” are weaker (especially running a loosely benchmarked portfolio).
To conclude, the basic implication here is that I am going take a slightly more “pragmatic” approach at the expense of a strict focus on value. At the moment, it seems to me that the current macro situation holds quite a few potential risks. We are going through a period of change (in my mind, similar perhaps to the late 1960s/early 1970s or even the 1920s) represented most simply by trade/capital account differences and exchange rate differences between developed and developing markets. I am very confident that this situation will resolve itself and everyone will benefit but the process of resolution involves difficult political decisions, globally, which take time. I am not saying that it is time to invest on these opinions but its important to recognize these risks. There is not enough recognition that value investing has suffered from quite a serious data mining problem in recent times with the Greenspan/Bernanke put. Value investing is, at its very simplest, a mean reverting strategy and so requires a calm macro background. I actively follow general macro conditions, current affairs and politics as it is just something I am interested in anyway but I think I have looked on the relationship between macro conditions and value investing with rose-tinted glasses and my performance has clearly suffered as a result of my attachment to “value” or “cheapness”. Practically, my main concern at the moment should be guarding the portfolio against any more macro risk exposure and looking for any opportunities that emerges as a result of this.
EDIT: Apologies for the mistakes in the first draft. Hopefully, it should be slightly more clear what I am trying to get at now.