Redefining and Reinventing Money Management

We can't compete with the market. Charlie Ellis has made that clear repeatably (supported by the evidence) for the last thirty years.

If we can't compete with the market what good are we (investment managers)? What value do we have? Where can we add value?

The industry is tied to a millstone. The S&P 500 (or the Dow Jones or some other arbitrary benchmark).

The quandary is that everyone wants performance. Everyone is conditioned to want performance. Everyone is focused on performance.

How do you wean yourself (your business, your clients) off this?

Do you say, "I can't beat the market. I'm not going to try to beat the market. The market is an artificial construct. We've been duped. Or, we've duped ourselves. We need to focus on your goals (but what if my goals require a level of return that the market is unlikely to provide?). We need to focus on protecting your accumulated savings and generating a little return without putting it all on the line."

Then what am I paying you for? If you're only going to use index funds and give me market, then I can do that myself and save myself 1% pa.

Advisers have basic expertise (they know the nature of the market and are aware of the most appropriate vehicles for structuring a portfolio/achieving a goal) impose a structure and discipline most savers/investors don't have. But what if investors through the discipline of the 401K process develop their own structure, discipline and expertise.

The process (maturation process) reminds me of developments in theology. Theology would move forward as it addressed the thoughts and concerns of the time. Someone would rise up and create a framework to take the conversation to the next level. And then new questions, problems, issues would arise and someone else would have to rise up and propagate a new paradigm with which to venture forth.

There Is No Single Best Solution, But...

There is no single best investment strategy, approach, philosophy, solution. There is no unified theory of investment management.

For long term investing, there are however a few simple things you can do to increase the chance of positive outcomes.

Get on the right side of secular trends, ie. exposure to growth, increasing productivity, rising earnings/free cash flows. One important factor is the valuation level you enter at. Secondary factors are short-medium term momentum and longer term mean reversion facilitations.

Have a underlying philosophy that takes out some of the more common errors or mistakes, ie. thinking you can consistently time the market, choose the best manager, or make the right stock picks. Passive, low cost, equal weighted exposure to global growth factors.

Have the humility to realize that you don't know it all and that you won't always get it right, therefore have a disciplined downside risk management framework that either includes strict stop loss limits and/or non-correlated asymmetric downside protection.

What A "New Normal" Might Look Like

I'm a 'new normal' kind of guy and I was just musing what a 'new normal' might look like. Here is what it might look like from an investment perspective in a generalized example:

T-5 T-4 T-3 T-2 T-1 Reset T+1 T+2 T+3 T+4 T+5
Revs ($m) 80 85 90 95 100 70 80 83.5 87 91 95
Profit Margin (%) 20% 20% 20% 20% 20% 5% 10% 10% 10% 10% 10%
P/S multiple (x) 2.5 2.5 2.5 2.5 2.5 1.5 1.8 1.8 1.8 1.8 1.8
Firm Value ($m)* 200 212.5 225 237.5 250 105 144 150.3 156.6 163.8 171
Return 6.25% 5.88% 5.56% 5.26% -58.00% 37.14% 4.38% 4.19% 4.60% 4.40%

*Firm value = Revs x P/S multiple

The table above assumes a 'new normal' world, ie. lower growth rates, lower multiples (higher risk premium), and lower margins - much of the 'new normal' hypothesis depends upon growth rates failing to return to normal (due to consumer deleveraging and increased taxes). Here are a couple of takeaways: (1) We experienced a 58% asset reset last year, reflecting an 80%+ decline in reported profits (I consider that the first wave of deflation), (2) We get a bounce gain of around 37% after the reset (already had it), (3) Firm value will take a long time to recover (hard to get back wealth losses if we're going into a 'new normal'), (4) To reduce the damage of the asset reset, you absolutely needed to stay in the market to capture the bounce.

I was astounded by the implications of the 'new normal' world wrt the loss of wealth (or firm value), but the biggest takeaway from this example is the fact that when you reset asset prices by 58%, long term expected returns are pretty good.

I could have used PE instead of PS for valuation purposes (I prefer PS, especially in a period like the present), and it would have conveyed the same sense.

P.S. Sorry the table looks bad. You'll have to bear with me on that one.