Monthly Archives: June 2009

Einstein On Investing

Amidst our nation’s obsession with pop celebrities, reality TV “stars” and those who are famous simply for being famous, we wish to briefly focus on someone truly worthy of the respect, adoration and media attention lavished on others – Albert Einstein. Granted, he left this mortal existence over 50 years ago and to our knowledge never sold a hit record, yet his theories about the nature of energy, light, matter and, indeed, the entire universe continue to profoundly impact our world. For example, the recent discussion between President Obama and Russian President Medvedev about reducing their nations’ stockpiles of nuclear weapons has at its heart a paper Einstein published in 1905. Although we have no hard evidence regarding Albert Einstein’s investment prowess, we suspect that he might have been pretty good at the “big picture” part of the process.

Albert is Smart, He’s a Genius

He is known as a theoretical physicist. Those of us who struggled through high school physics may remember that physics is the study of how things work – from the sub-atomic level up to the interaction among the stars and galaxies which populate the universe. A theoretical physicist would try to explain how things work with theories, formulas and ideas, rather than measurements and observations. This makes this kind of physics even harder for the average person to understand. This suggests that Einstein was not only incredibly smart, but super smart in a very challenging field.

He’ll Be Scribbling Things, Genius Things

Einstein published his first paper in 1902, trying to prove that atoms exist and that they have a finite, non-zero size (something that was still uncertain in the physics world at the time). Although his work did not receive immediate praise, this early work did show the promise which was to blossom in a spectacular fashion within the next few years. For Einstein, 1905 is considered his Annus Mirabilis (extraordinary year) and his work in this year propelled him into the elite circle of great scientific minds where the likes of Newton, Galileo and Aristotle reside. He also won a Nobel Peace Price for his efforts.

In 1905, Einstein published four major papers which revolutionized the physics community and ultimately led to the development of nuclear energy. A brief review of basic findings of these papers can provide some valuable insights into the physics of the investment world.

Photoelectric Effect. – Light, the “stuff” that makes our crops grow, allows us to see colors and most importantly, makes life itself possible on our planet, seems pretty straightforward. Any child can tell you what light is, why it’s good and what it’s good for. But to an early 20th century physicist, light was an enigma. Many thought that light traveled in waves, like sound. Some, like Einstein, thought that light was actually made up of some kind of particles. His paper on the photoelectric effect “proved” (at least in a theoretical way) that light is comprised of discrete packages which he called “quanta.” Modern physicists have refined Einstein’s pioneering work here, and we now know that light is comprised of things called “photons,” but light also continues to display wave-like properties. Einstein was able to prove something that no one could see.

Investment implications. Some things in the investment world are ubiquitous and simple to observe, like stock prices. Anyone, at any time, can measure the price of a stock. But what a stock price really, truly represents; what forces are impacting a stock price at any given time; or why a stock trades as it does are issues much more complicated than the casual observer can truly understand. And understanding these complex forces and their impact on stock prices is the most basic and important step to understanding how to invest. Without this understanding, stock investing becomes nothing less than an exercise in randomness.

Brownian Motion. – Atoms are very small; invisible to the naked eye. Yet, their existence was posited by Indian and Greek philosophers as early as 2,000 years ago. In Einstein’s day, the grand atomic debate centered on whether atoms were real or simply a nice idea, something which helped explain lots of things physicists care about. Einstein was able to prove their existence by postulating what the motion of an atom that had a non-zero finite size would look like and then actually measuring and showing that exact motion. He also devised an experiment whereby one could see this effect (and thus “see” atoms) under a microscope.

Investment Implications. Some important factors which impact our investment decision are hard to see (monetary policy or investor sentiment, for example), but can be measured in one way or another. By accurately measuring and understanding them, one can gain better insight on how the markets operate. Just because something seems small and hard to grasp does not mean it cannot have a big impact on the price of a security or the capital markets at large.

Special Relativity – This theory is a little more complicated, but in simple terms it suggests that all uniform motion is relative and that there is no well-defined state of rest. A simple way to explain this is to consider a person bouncing a tennis ball on a train. To a person in the train, the ball goes down and then comes right back up. To someone watching this from a distance (assuming this person could indeed see the ball), the ball’s trajectory would look like a wide “V” pattern, the horizon movement of the ball being a function of the train’s movement. So what is the “real” motion of the ball? Einstein proved that it would be relative to the point of view of the observer. Another important result of this paper was the notion that the speed of light is constant in all frames of reference.

Investment Implications. Often a person’s point of reference can influence his or her opinion on a security. Consider Person A, who bought stock XYZ at $10, and Person B, who bought the same stock (at a different time of course) at $30. The stock now trades at $20. Person A is feeling pretty good about XYZ, given the 100% gain Person A has in the stock. Person B on the other hand considers XYZ a “dog,” having lost 50% in it. Yet, XYZ has a valuation, outlook and potential irrespective of where one might have bought it. This concept is at the heart of our equity research – we try to assess value and potential regardless of perspective. Not every stock we buy will appreciate. All along the stock’s trajectory, we try to measure its value and potential. Like the speed of light, some investment principles, like valuation and reducing risk by diversification, are fixed, constant, and independent of point of reference.

Matter and Energy Equivalence. E=mc2. This simple little formula was perhaps Einstein’s greatest achievement. He was able to show (theoretically, of course) that the energy of an object at rest (E) is equal to its mass (m) times the speed of light squared (which, by the way, is a really big number = 8.98755 x 1016 m2 s2). The brilliance of this theory was shown (in very dramatic fashion, by the way) at the scene of the first atomic explosion (July 16, 1945), where a very small amount of plutonium (less than 2 pounds) created an explosion with the power equal to 20 kilotons of TNT. Einstein was right; mass can be converted into energy.

Investment Implications. Other than some weak joke about one’s portfolio “blowing up,” we would suggest that sometimes we see an event or a data point that seems small and inconsequential by itself, but can have a profound impact because of the circumstances in which this event occurs. Sometimes we will see a stock move down a large amount simply by missing its earnings expectation by a penny. A specific example would be the Lehman Brothers bankruptcy. Many companies go bankrupt each year without damaging the economy or the capital markets. Lehman’s failure, on the other hand, led to a near total seizing up of the capital markets and led to much of the angst and trauma all investors experienced last year. In the markets, some little things can have a huge impact.

One does not need to be a genius to be a successful investor (not that it wouldn’t hurt to be one); simply following basic, time-testing rules of investing (diversification, value, etc.) can lead to excess returns for the disciplined and patient investor.

Celebrity Deaths

This week the entertainment business lost three famous people – Michael Jackson, Farrah Fawcett and Ed McMahon. Someone once told me that celebrity deaths tend to come in threes, and this week is another example of this. I am not going to spend much time discussing their passing, but I do wish to send my condolences to their families. Celebrity deaths affect us so much because we feel like we really know these people; like they are a real part of us. I, for one, have enjoyed the work of all three of these people over the years. But as I read the obituaries, I was struck with one very harsh reality – the entertainment business is extraordinarily competitive and “what have you done for me lately” is a huge part of it. Longevity in the entertainment business is hard to come by (unless you’re Mick Jagger or Christopher Lee).

And this leads to today’s musing about the investment business. Unlike some professions where a person may be engaged in a project that starts, has a middle, and then ends, being a professional investor means your work is never through. Luckily, the markets are not open throughout the weekend, but Barron’s comes every Saturday so we can keep thinking about the key issues which occupy our minds during the working week. I am not complaining at all; this is the life I chose and I love it. It’s just that I am acutely aware (as are all professional investors, I suppose) that I am always thinking about the markets, obsessing on how I can perform better and worrying about what’s going to happen in Tokyo while I am asleep.

There is also a very strong “what have you done for me lately” aspect in this business as well. When a stock I buy goes up, I feel somewhat vindicated that all my hard work in researching, analyzing and actually buying the stock has paid off. Yet, unless I sell that stock and move on, every new day brings the potential for some unforeseen and unexpected event that could drive the stock down. It is not necessarily random, but it is an adventure in probabilities and some things simply cannot be avoided (the Black Swans, if you will). Right or wrong, up or down, I am applying the same level of analysis and dedication to each and every fund and stock I work on. My approach does not change and I clearly do not view my worth as an investor simply by how well my stocks have done in the last few months (last few years, yes).

Client reactions can also follow this “what have you done for me lately” mentality. Some folks who were questioning my judgment, experience and perhaps even sanity back in March, now view me much more favorably. What’s changed? I had the investment equivalent of a hit song or movie. Performance has been very strong lately. Part of this near-term success was due to my making very hard, contrarian and seemingly “crazy” decisions earlier in the year. Part of it was simply sticking to my guns when the consensus was suggesting that all past investment principles had been declared null and void. Part of it was simply the law of the harvest (you reap what you sow) as it applies to the investment process.

I feel a modicum of self-satisfaction as I wave modestly to the crowds, but I know full well that after the applause dies down, I will have to get back in the trenches and dig harder to find those choice nuggets amid all the dirt. It’s a dirty job, but hey, someone’s got to do it…

Are You Being Served?

I am amazed at how much time and effort goes into media reporting about the capital markets. The vast array of Internet, print and broadcasting coverage is truly astounding. We can now enjoy (if that is indeed the right word), 24/7 coverage of all the markets and all the factors that influence them. Every day we can see periodic updates on commodities, bond prices, economic data, government press releases, currency rates, and on and on. An investor might look at all of this coverage and data and reasonably conclude that he or she is pretty well served by all of this. After all, there must be demand for this kind of stuff, otherwise why would they keep churning it out?

But is the investor really being well served?

It seems to me that capital market reporting falls into two basic areas: 1) Here is what happened and 2) Here is what the experts think about this. Whether it’s an earnings release, market trend (higher commodity prices, etc.) or some kind of event (a bankruptcy, for example), the media is all over this “news” with commentary and analysis.

Regarding 1) — Call me old fashioned, but I thought the stock market was supposed to discount future events and trends. In theory, what is happening right now should have been discounted by the market weeks or even months ago. This is often the reason that when a company reports earnings below (for instance) consensus, the stock can actually rise on that “news.” Sometimes the market is truly surprised by some news and this is probably worthy of the attention it gets. Trouble is, the media seems to struggle with which items are real surprises and which are really already known by the market. The other big issue I have with most of the commentary I hear from the media, is that it rarely puts the event or news item in any kind of investment context. Great, the unemployment number was X – but how does this number fit into the recent trend? Are there details in the other numbers (beside the headline ones) of the report which may provide some insight as to what the numbers are really suggesting? What is the bond market saying about this number? What about the forex market? Why was this number 25% below the lowest estimate from among all the 76 people providing estimates for it (this was true for the May 2009 jobs number)?

Regarding 2) – Where do they get these people? It seems the media can always find some “expert” to ruminate on any given topic, no matter how big or small, arcane or mainstream, controversial or commonplace. More often than not, this “expert” will be the person with an opinion or outlook quite far away from the consensus — the average is boring, no? At least in the media’s view… So, inevitably, this person’s viewpoint and forecast will often contain a high degree of error attached to it (mathematically, this has to be true, if this person’s opinion is far from the consensus; it could prove to be correct, but statistically, the odds would be lower). Often, the media will line up an investment professional (trader, mutual fund portfolio manager, analyst, etc.) to comment on some trend or stock.

Now let me ask a very direct question – why would someone appear on television and offer, for free, a value-added opinion that could help some make money in the market, when this person has clients who will pay for that opinion? Other than the answer that comes from an old Eagles song (… it’s a certain kind of fool who likes to hear the sound of his own name”), I would argue that NO ONE would do that. In my experienced (and obviously cynical) opinion, these folks are SELLING SOMETHING! It may be that they want you to buy a stock they already own. It may be that they want to you to be impressed with their searing intellect and buy their fund. It may be they are just amassing face time which will help them sell their next book. Whatever the motivation, I think it is safe to say that the interests and needs of the individual investors listening to their story may not be at the top of their priority list.

I have always thought that investment advice is worth what you pay for it. Those offering free advice have no fiduciary responsibility, cannot offer opinions appropriate for the needs of specific investors and are not accountable in any way for their opinions. You certainly would not buy a used car from a person who had this kind of freedom from consequence. Why would you ever buy a stock based on this kind of opinion?

Backs Turned Looking Down the Path

Now that I am no longer operating full time in “crisis management” mode, I thought it might be instructional to look back and reflect on this things I did during the last nine months, which, in case anyone might wonder, has been the most challenging period in my career. This exercise will represent a debriefing, if you will — an attempt to look back objectively at what happened, how I responded to what happened and what I might have learned from the experience.

Let me start by explaining what I did not do:

1) I did not sell stocks in October 2007, which turned out to be the peak of the market. At that time, the market did not exhibit any of the excesses we generally associate with market peaks. The excesses were located squarely in the housing and credit markets. I had no specific information showing how leveraged the banks and brokers were, nor how this leverage would spill over into the stock market and the general economy. Past bubbles had burst without threatening the entire global financial system. It was not obvious that bursting this one would have that impact.

2) I did not sell stocks to hold cash at any time during this period. I am not a market timer, and I don’t think anyone can do this successfully over time.

3) I did not abandon my long-held personal investment philosophy. It has worked for many decades and I suspect it will work for more decades to come.

4) I did not panic.

Here are a few things I did that I think served me well:

1) By October, I recognized that the situation had quickly deteriorated and that the markets had stopped functioning in a normal fashion. Once the VIX (CBOE Volatility Index) broke the 40 level (which had for years been its peak), I felt that the market could become very volatile. When Lehman Brothers fell and the credit markets seized up, the real trouble began. Still, I had personally experienced the Crash of 1987 and the Long-Term Capital Crisis of 1998, and so I truly felt that we could ride through this one as well. I kept analyzing companies and tried my best to assess the value of stocks – this is my training; this is what I do. Sitting around worrying about what might happen is never a productive activity.

2) By November, I was buying stocks. One of the downsides of being a value investor is that you rarely ever own the stocks everyone loves to talk about – the new and shiny ones with great stories and sex appeal. It’s kind of like driving a Ford Focus when everyone else is driving BMWs. However, starting in November many of the BMWs were going for prices usually associated with Fords. So, compelled by the value I was seeing, I began to nibble at not just the beat-up value stocks, but many of the growth names I had never owned before. The valuations were more compelling that the uncertainty about the future.

3) By early March, I was stubbornly holding my ground. By this time, every single “doom and gloomer” was in full froth mode, telling anyone who would listen (everyone in media, it seems) that the world was truly ending. The January through March decline was very hard for me – the reasons for the decline were even harder for me to understand – the VIX was down and the capital markets were once again working. Why was the market still going down? Was it mostly driven by retail selling? Mutual fund redemptions? Hedge Fund deleveraging? Maybe someday someone will write a book with definitive answers. I did not know that March 9th was the bottom, but I did feel that retail investor panic was peaking that week.

4) I kept working. Go back and read my blogs from February and March. In them you can see that I was closely following the events of the day and trying my hardest to make sense of it all. The best paragraph (in my humble opinion) of the month was this one from my March 9th post:

“Unless ‘this time is different’ (still the four most dangerous words in the investment business, in my view), the stock market will begin climbing the proverbial wall of worry, long before the talking heads will be able to tell us that the recovery has begun.”

Crises, panics and manias are always hard to deal with, but they are absolutely the natural product of open capital markets. No amount of legislation can prevent them. The best way to deal with them, in my opinion, is to 1) understand the risks associated with the markets, 2) understand your investment time horizon and 3) develop a personal investment philosophy that can support and sustain you during the hard times. The last nine months have been a huge challenge, and lots of people have lost a great deal of wealth. But, I firmly believe the only pathway leading to any hope of recovering that wealth will take us directly through the middle of the stock market. Once again.