Risky Business

risky-business-porsche-posterThe Risky Business Report, a bipartisan project backed by three former U.S. Treasury Secretaries as well as other political and business leaders that seeks to quantify and publicize the economic risks from the impacts of a changing climate, calls for new policies to “reduce the odds of catastrophic outcomes” from extreme heat and rising sea levels linked to climate change. Such severe impacts will likely cost billions of dollars in annual property loss, threaten human health. lower labor productivity and endanger the nation’s electricity grids, according to the report The findings summarized by the report also show that the most severe risks can still be avoided through early investments in resilience and through immediate action to reduce the pollution that causes global warming.

“I know a lot about financial risks — in fact, I spent nearly my whole career managing risks and dealing with financial crisis,” former treasury secretary (under George W. Bush) Henry M. Paulson Jr. says in the report. “Today I see another type of crisis looming: a climate crisis. And while not financial in nature, it threatens our economy just the same.” Continue reading

The Tragedy of Errors

Lawn Chair LarryLarry Walters had always wanted to fly.  When he was old enough, he joined the Air Force, but his poor eyesight wouldn’t allow him to become a pilot. After he was discharged from the military, he would often sit in his backyard watching jets fly overhead, dreaming about flying and scheming about how to get into the sky. On July 2, 1982, the San Pedro, California trucker finally set out to accomplish his dream. But things didn’t turn out exactly as he planned.

Larry conceived his project while sitting outside in his “extremely comfortable” Sears lawn chair. He purchased weather balloons from an Army-Navy surplus store, tied them to his tethered Sears chair and filled the four-foot diameter balloons with helium. Then, after packing sandwiches, Miller Lite, a CB radio, a camera and a pellet gun, he strapped himself into his lawn chair (see above). His plan, such as it was, called for his floating lazily above the rooftops at about 30 feet for a while and then using the pellet gun to explode the balloons one-by-one so he could float to the ground.

But when his friends cut the cords that tethered the lawn chair to his Jeep, Walters and his lawn chair didn’t rise lazily. Larry shot up to a height of over 15,000 feet, yanked by the lift of 45 helium balloons holding 33 cubic feet of helium each.  He did not dare shoot any balloons, fearing that he might unbalance the load and cause a fall.  So he slowly drifted along, cold and frightened, with his beer and sandwiches, for more than 14 hours. He eventually crossed the primary approach corridor of LAX.  A flustered TWA pilot spotted Larry and radioed the tower that he was passing a guy in a lawn chair at 16,000 feet.

Eventually Larry conjured up the nerve to shoot several balloons before accidentally dropping his pellet gun overboard. The shooting did the trick and Larry descended toward Long Beach, until the dangling tethers got caught in a power line, causing an electrical blackout in the neighborhood below. Fortunately, Walters was able to climb to the ground safely from there.

The Long Beach Police Department and federal authorities were waiting. Regional safety inspector Neal Savoy said, “We know he broke some part of the Federal Aviation Act, and as soon as we decide which part it is, some type of charge will be filed. If he had a pilot’s license, we’d suspend that. But he doesn’t.” As he was led away in handcuffs, a reporter asked Larry why he had undertaken his mission. The answer was simple and poignant. “A man can’t just sit around.” Continue reading

The One Percent Doctrine

One Percent DoctrineA number of years ago, during George W. Bush’s second term and by sheer happenstance, I ended up playing a round of golf with a Navy SEAL Commander (half the SEALs train here in San Diego).  Obviously, much of his job was classified and he was very circumspect in what he shared.  However, when I asked where or how I could become better informed about foreign policy, he recommended Ron Suskind’s book, The One Percent Doctrine.

The “one percent doctrine” (also called the “Cheney doctrine”) was established shortly after 9.11 in response to worries that Pakistani scientists were offering nuclear weapons expertise to Al Qaeda. Here’s the money quote from Vice President Dick Cheney: “If there’s a 1 percent chance that Pakistani scientists are helping al-Qaeda build or develop a nuclear weapon, we have to treat it as a certainty in terms of our response. It’s not about our analysis … It’s about our response.”

Thus in Cheney’s view and per subsequent policy, the war on terror required and empowered the Bush administration to act without the same level of evidence or analysis as might otherwise be necessary.  Continue reading

FOBOR or FUBAR?

FUBARIn a no-yield world, many perceive themselves as “forced buyers of risk” (FOBOR). By way of example, the Financial Times reported the following note from BofA Merrill Lynch:

In a world of zero rates, where $19.4 trillion of government bonds (that’s 48% of the total market) is trading below 1%, it’s little wonder the “lust for yield” is as strong as it is. Last week Rwanda offered 6.875% 10-year bonds to borrow $400mn, an amount equivalent to 5.5% of its 2012 GDP. The offer was 9-10X oversubscribed. And Panama successfully issued a $750mn 40-year bond with a 4.3% coupon (note that in the past 50 years the US 30-year Treasury bond has traded below 4.3% for just 10% of the period).

In what universe does it make sense for people to fight to loan Rwanda money at 6 7/8 percent?

Size Matters (More)

size mattersMy recent post on the small-cap premium and my tentative hypothesis that sub-linear scaling in companies helps to explain it has received a substantial amount of interest — privately, publicly, and even a bit in the comments. Due to the remarkable response, I wanted to add a few clarifying points.

  1. I don’t suggest that the sub-linear scaling Geoffrey West discovered within companies fully explains the small-cap premium.  There are a number of factors at work (including risk, the standard explanation for the small-cap premium), and these can cut in a variety of ways.
  2. Most of the criticism centers upon the (very tentative) conclusion rather than the data.  If the data is accurate — and I see no reason to doubt it to this point – it suggests that smaller companies, once they have reached something like critical mass, are decidedly more efficient than larger companies.  That added efficiency, if and when fully verified, would indeed support both the existence and the persistence of a small-cap premium.  Those who disagree with the (again — very tentative) conclusion must still account for the data.  To this point, none of the critics has even made an attempt to do so.
  3. Further discussion and (especially) further research will be necessary to see if this idea holds up.  I emphasize that it remains merely a hypothesis to this point. It seems consistent with and supported by the data but remains in need of verification.

As always, comments and criticisms remain welcome.

The Missing Lead

big_butt_chairI’m a big fan of Jake Tapper.  I thought he was terrific at ABC News as the senior White House correspondent and I was disappointed when he wasn’t picked to host This Week both when George Stephanopoulos left in 2010 and when he came back in 2012.  As of 2013, Jake returned to CNN to become Chief Washington Correspondent and anchor of a new weekday television news show, The Lead with Jake TapperThe Lead, which debuted this week to generally good reviews, is the first CNN show to launch since Jeff Zucker took over as president of CNN Worldwide to revitalize the franchise.

I agree with the good reviews, but there’s a “big but” coming. Continue reading

My Top Posts for 2012

The following dozen Above the Market posts were read, quoted and linked the most during 2012 and are listed below in order of popularity.  I think they provide a pretty good cross-section of this site and what I am about.  I trust that you will enjoy each of them again or enjoy them afresh if you may have missed them the first time around.  I am most appreciative of all the attention and support I have received.  Thank you all very much.

Doubling Down on Disaster

In early 2000 I was at a big pitch extravaganza for the soon to launch Merrill Lynch Focus Twenty fund.  Mother had snapped up star manager Jim McCall from PBHG to start and run the fund which was designed to hold McCall’s 20 best ideas.  These were, ubiquitous for the times, all very aggressive growth (and mostly tech) firms, even though the terms of the fund allowed him to invest virtually anywhere.  The “focus” idea was to avoid diversification so investors could really make money when the “best ideas” popped, since the fund was to be aggressively traded too. At PBHG, McCall managed its Large Cap 20 fund. In the two and a half years Mr. McCall ran it, that fund raked in average annual returns in excess of 50 percent.

McCall had to wait more than a year to start at Merrill due to a contentious departure from PBHG and the resulting litigation.  He had been a successful stock picker and Mother paid a fortune (undisclosed) to win his services. At the time, Merrill was known primarily was a value shop, but McCall was upfront about his lack of interest in valuations or profitability.  His focus (so to speak) was the “new economy” — a good story with earnings and growth momentum, albeit from a tiny base.  ”Valuation is not one of the factors that enters into our methodology,” McCall said repeatedly.Dead Bull

At the pitch, we were told to get in while the getting was good.  Tech was hot and there was lots of money to be made.  Risk?  What risk?  We were pitched hard.

The fund launch was a huge success, with initial assets in excess of $1 billion and an initial share price of nearly $9.  And, back then, $1 billion was real money.  Assets later exceeded $1.5 billion and the price peaked above $10. 

I didn’t buy the fund for myself and I didn’t sell any of it either.  At lot of people thought I was nuts but things turned out all right for me if not for McCall.

The Focus Twenty launch came at the height of the tech bubble and of the hubris that characterized that time.  But barely a year later, Focus Twenty had the ignominious distinction of ranking in the bottom 1 percent among funds of its kind for the previous day, week, month, quarter and year and was down roughly 80 percent.  McCall refused to capitulate and kept doubling down on his strategy, all the way to the bottom.  Before 2001 ended, McCall was gone and has barely been heard from since.

As Morningstar said at the time, “McCall’s short tenure at Merrill has been an unqualified disaster.”

The easy lesson to draw from the Focus Twenty debacle is the importance of diversification. But what sort of diversification?  Market diversification protects against idiosyncratic risk.  But without idiosyncratic risk, you might as well hold index funds.   

By definition, active managers have clear points of view with respect to what is rich and what is cheap.  Concentration (pardon the pun) on selling what is richest and buying what is cheapest is how active managers go about trying to beat “the market” (and it is usually an index that benchmarks whether they have done so).  Diversification in that sense means that an active manager is in reality a “closet indexer” and, on account of lower fees, they will find it essentially impossible to beat the market long-term. Active managers want concentration rather than diversification.

However, even the best and most successful active investors make mistakes and have down periods – which can last significant periods of time.  This problem is particularly acute during secular bear markets which last, on average, about 17 years. The current one began in 2000, just after the launch of Focus Twenty. During these secular bear markets, equity markets are prone to strong cyclical swings in both directions.  In 1977, during a previous secular bear market, Time magazine called this phenomenon a “roller-coaster to nowhere.”

So if you are committed to active management, which favors concentration, how do you avoid disasters like McCall’s?  The best way for most individual investors is probably to maintain concentration within investment vehicles while owning such vehicles in at least several market sectors.  That said, for individuals and professionals alike, the active management investment process needs to be a very good one to succeed.  What’s hot can remain so for an agonizingly long time even though the strategy is anything but a long-term winner.  Growth investing worked for a long time during the tech bubble, but valuations matter longer-term.  Some approaches and factors have stood the test of time for making investment decisions – such as value, size and momentum.  Make sure your activist approach can be supported by the data.

Finally, it is crucial to remember that what’s true in investing today may not be true tomorrow.  We must not be capricious and must insist on a careful and data-driven orientation.  But we also need to be open to new and better evidence. 

As Tadas Viskanta so often says, investing is hard.  There are no guarantees.  Just ask Jim McCall.

The NFL, Data and Player Safety

This season the National Football League introduced a full season’s worth (actually, 13 weeks, with games featuring every team) of highly valuable Thursday night games for the first time, all televised by the league-owned NFL Network.  Many players have gone on record complaining about the Thursday scheduling due to injury concerns.  Bill Simmons of Grantland, the world’s most famous sports blogger, has been the most prominent among many critics of the Thursday night match-ups, profusely criticizing NFL Commissioner Roger Goodell for putting players’ health at risk by scheduling games on such short rest. For example, Simmons cites the case of the Baltimore Ravens, who played four games in 17 days at the start of the season and subsequently suffered a rash of injuries, including the losses of star cornerback Lardarius Webb and future Hall of Fame linebacker Ray Lewis for the season (although Lewis may well return ahead of schedule). The Thursday night games have also been very sloppy, presumably due to a lack of both practice and recovery time, and last night’s match-up was no exception.

During his wide-ranging news conference earlier this week, Goodell claimed that ongoing efforts will continue to make the game safer.  Injuries have been a major focus of late, particularly as they relate to concussions and brain trauma.  But Goodell also asserted that there was no data to support the idea that the short weeks cause more or more serious injuries.  “We don’t have any information that indicates from our data that playing on Thursdays in any way decreases the safety of our players,” Goodell said.  “The injury rates do not indicate that at all over the years.  So I think we start with facts, and the facts are that that’s not a risk to the players.”  He may even be right.  Moreover, since the players’ union has approved the games, player complaints aren’t likely to make a difference any time soon (for at least as long as collective bargaining agreement remains in force).

There is pretty good reason to believe that the Commissioner is being more than a little hypocritical generally when it comes to player safety, but for the purposes of this exercise, let’s assume that his actions were and are entirely well-intentioned and that there really is no data supporting the idea of increased injury risk on Thursday nights.  As my masthead suggests and as I have written repeatedly (for example, here), I am committed to data-driven analysis — in investing and elsewhere.  But how should we deal with a lack of data?

As an initial matter, it is important to note that a lack of data is not the same as a lack of evidence.  There is a lot of testimonial evidence from the players — albeit anecdotal and incomplete evidence – that playing on Thursday is a serious risk.  The lack of data confirming that testimony may be because the player narrative is wrong.  But it may also be because there isn’t enough experience yet for the data to be meaningful or because the right measurements aren’t being taken (for example, the number of injuries may not go up on Thursday nights, but their severity might).  Remember, this is the first year that we have seen a full slate of Thursday night games.

The difficult question is how to select the appropriate default in the event that there isn’t any data or where the data remains inconclusive.  In most instances, it makes sense to maintain current practice if there is no data suggesting otherwise.  But when current practice is new or relatively new, it may be prudent to rely on anecdotal testimonial evidence alone if it sufficiently compelling.

That leads, obviously, to the issue of what kind of evidence is or should be “sufficiently compelling.”  In general, if the risks of proceeding are high, the threshold of evidence needed should be pretty low and vice versa.  Moreover, the types of risk are extremely important.  The NFL has a lot of money invested in Thursday Night Football, largely in the form of the NFL Network.  The financial stakes are enormous and they are known.  But the human injury risks are also huge, even though they remain — at least at present — somewhat speculative.

The appropriate conclusion, then, seems to depend upon how you measure and value the clear economic consequences of cancelling Thursday night games as compared to the serious but somewhat speculative injury risks alleged by many players.  There is no clear answer and the individual conclusions drawn will be predicated largely upon one’s values and priorities, not to mention any personal stake one might have in the outcome.  Roger Goodell works for the league and NFL owners, whose financial interests are at stake, which will obviously influence his conclusions (confirmation bias demands it).  The players face no financial risk, at least directly, but face a serious risk of injury (and thus career risk, with serious financial repercussions) every time they step on the field.  That reality will obviously influence their conclusions (confirmation bias demands it).

For me, the answer is clear (but remember that I’m biased too — one of my sons was a Division I college football player whose career was cut short by injury).  In my view, dynamic Baltimore Ravens safety Ed Reed said it best. “If they are really concerned about the violence and injuries . . . Why is there Thursday night football?” 

Why is there Thursday Night Football indeed?

What Will 2030 Look Like?

The National Intelligence Council is composed of the 17 U.S. government intelligence agencies.  The Council’s Global Trends Report has, since 1997, worked with a variety of experts both in and out of government service to examine factors such as globalization, demography and the environment to produce a forward-looking document to aid policymakers in their long-term planning on key issues of worldwide importance. 

“We are at a critical juncture in human history, which could lead to widely contrasting futures,” wrote Christopher Kojm, the Council’s Chair, in his introduction to the current Report, published just this week.

The Report is intended to stimulate thinking about the rapid and vast geopolitical changes characterizing the world today and possible global trajectories over the next 15 years. Significantly, it does not seek to predict the future – we have a dreadful track record in the regard – but instead it seeks to provide a framework for thinking about possible futures and their implications.

The Report argues that the breadth of global change we are facing today is comparable to that during and surrounding the French Revolution and the rise of the Industrial Age in the late 18th century, but it is being realized at a much faster rate. While it took Britain more than 150 years to double its per capita income, India and China are set to undergo the same level of growth in a tenth of the time, with 100 times more people.

I encourage all investors to read it carefully.  Despite the vital importance of the “long cycle,” it isn’t likely to change your current portfolio outlook, but it will provide a helpful backdrop to your overall thinking and to your longer-term outlook and analysis.

Among the Report’s conclusions is that there are certain “megatrends” that are relative certainties and that we should prepare to deal with them.  These include the following (and note that all have investment implications, some of them potentially enormous).

  • For the first time in history, a majority of the world’s population will no longer live in poverty by 2030, leading to a healthier global population and a major expansion of the middle classes in most countries.
  • Life expectancies will continue to expand rapidly.  “Aging” countries (such as those in the West – particularly Europe – and Japan) face the possibility of a significant decline in economic growth.
  • Asia is set to surpass North America and Europe in global economic power, but there will not be any hegemonic power.
  • Demand for resources will increase owing to global population growth from 7.1 billion people today to about 8 billion by 2030.
  • Demand for food is likely to rise by 35 percent and energy by 50 percent over the next 15-20 years.
  • Nearly half of the world’s population will live in areas with severe water stress by 2030.  Fragile states are most at risk, but China and India are vulnerable to volatility of key resources.

These megatrends will inevitably lead to a variety of vexing and potentially “game-changing” questions.  Each has profound political, economic, market and human implications.

  1. Will divergences and increased economic volatility result in more global breakdown or will the development of multiple growth centers lead to increased resiliency?  For much of the West, the challenges involve sustaining growth in the face of rapidly aging populations. For China and India, the main challenge will be to avoid “middle income traps.” In general, the global economy will be increasingly crisis-prone and won’t return to pre-2008 growth levels for “at least” the next decade.
  2. Will current governments and international institutions be able to adapt fast enough to harness and channel change instead of being overwhelmed by it?  While this sounds generally like the investment challenge we face daily, there are a variety of major global issues in this regard.  Potentially (more) serious government deficits driven by rapid political and social changes are likely to exist. Countries moving from autocracy to democracy are often unstable and about 50 emerging market countries fall into this major risk group.  All of them could – at least potentially – grow out of their governance incongruities by 2030 if economic advances continue.
  3. Will rapid changes and shifts in power lead to conflicts?  The general answer is surely duh, with uncertainty only as to the number, extent and nature of the conflicts.  Limited natural resources—such as water and arable land—in many of the same countries that will have disproportionate levels of young men—particularly in Sub-Saharan Africa, South Asia, and parts of the Middle East—increase the risk of intrastate conflict.  It is particularly troubling to note that any future wars in (at least) Asia and the Middle East may well include a nuclear element. Many of these conflicts, once begun, would not be easily containable and would (obviously) have global impacts.
  4. Will regional instability, especially in the Middle East and South Asia, spill over and create global insecurity?  See the commentary re #3 above.  Wash; rinse; repeat.
  5. Will technological breakthroughs occur in time to solve the problems caused by rapid urbanization, strains on natural resources, and climate change?  The report identifies 16 key “disruptive” technologies with potential global significance out to 2030. They are generally grouped around potential energy breakthroughs, food- and water-related innovations, big data and the forecasting of human behavior, and the enhancement of human mental and physical capabilities, including anti-aging.
  6. Will the United States, as the leading actor on the world stage today, be able to reinvent the international system, carving out potential new roles in an expanded world order?  The Report anticipates that the U.S. will likely remain primus inter pares (first among equals) among the other great powers in 2030 because of the multifaceted nature of its power and legacies of its leadership.  But it also expects that the “unipolar moment” is over. Overall, power will likely shift to networks and coalitions in a multipolar world. The United States’ (and the West’s) relative decline is seen as inevitable but its future role in the international system is much harder to project. China is deemed unlikely to replace the U.S. as international leader by 2030.  Non-state actors and even individuals, empowered by new media and technology, will be an increasing threat.  A reinvigorated U.S. economy – spurred perhaps by U.S. energy independence – could increase the prospects that the growing global and regional challenges would be addressed. However, if the U.S. fails to rebound, a dangerous global power vacuum would be created.

From these building blocks and issues, the Report posits potential  futures including a best-case scenario of increased cooperation between the U.S., China and Europe as economic and security interests increasingly align, a worst case scenario of conflict and fragmentation in a stalled global economy where political, social and economic inequalities work against integration and stability, and a scenario involving a “nonstate world,” where the nation-state does not disappear, but countries increasingly organize and orchestrate “hybrid” coalitions of state and nonstate actors which shift depending on the issue.

There is no earth-shaking news here.  But it is helpful to take a step back and look at the bigger picture once in a while.  Because change is so often incremental, it is easy to underestimate how quickly it can happen and how much impact it can have in the aggregate.  In the markets as in life, caveat emptor.