Play To Win Or Go Out Like Broomcorn’s Uncle

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There is a passage from a classical Chinese text, written thousands of years ago, that describes the plight of many struggling traders today.

It’s from The Zhuangzi and translates as follows:

They are consumed with anxiety over trivial matters but remain arrogantly oblivious to the things truly worth fearing. Their words fly from their mouths like crossbow bolts, so sure are they that they know right from wrong. They cling to their positions as though they had sworn an oath, so sure are they of victory. Their gradual decline is like autumn fading into winter ­­this is how they dwindle day by day. They drown in what they do­ you cannot make them turn back. They begin to suffocate, as though sealed up in a box­­ this is how they decline into senility. And as their minds approach death, nothing can cause them to turn back to the light.

Bleak stuff indeed. So how does it apply to struggling traders?

Well, first consider there is a whole contingent of people familiar with “the rules,” yet still not satisfied with their results or where they have wound up. And when I refer to “the rules” in air quotes, I mean the stuff you will find in just about every trading book that was ever published.

Stuff like this:

● Cut your losses and let your profits run.
● The first loss is the best loss.
● Always plan your trade and trade your plan.
● Trade with the trend.

Now hold on, isn’t that stuff legitimate? Don’t all those old truisms have merit?

Sure they do. But they certainly aren’t enough ON THEIR OWN MERITS to succeed in trading. If you hang out on trading websites, or in the trading and investing section of bookstores, you will find those “truths” posted everywhere. You will hear them preached like gospel, with an implied message of profit salvation.

Yet those wise old truths sure haven’t helped the vast majority of traders who can parrot them. There are no bonus points (let alone extra profits in the trading account) for being able to recite that stuff in your sleep.

That Zhuangzhi passage reminded me of struggling traders who stick to “the old truths”… despite a perpetual track record of sub-par performance. They never do anything special, never make life ­changing profits, and never actually­­ ­­experience enough success to feel like they have truly succeeded at trading.

Let’s break down the Zhuangzhi passage sentence by sentence and see how it can apply to struggling traders.

They are consumed with anxiety over trivial matters but remain arrogantly oblivious to the things truly worth fearing.

You know the thing that is REALLY worth fearing?

Time, or rather, the loss of opportunity to learn and grow, which primarily relies on time as an input.

With time comes opportunity to learn. With opportunity to learn comes opportunity to grow… and with sufficient growth one can find the necessary breakthroughs to reach full potential.

The passage of time in the absence of real growth ­­when time is wasted spinning one’s wheels ­­is such that core lessons are never learned… core breakthroughs are never experienced… and then, time’s up!

You can always earn more capital… unless you run out of time.

That is why one might argue it is far better to blow up a few trading stakes at small recoverable levels, and learn quality lessons from the experience, than to stay at hobbyist level permanently.

By the way, regarding the strategy of blowing up early to acquire seasoning and skills — that is exactly what Paul Tudor Jones did. He understood that the point of trading small was learning the ropes in order to trade big… which meant pushing the envelope and learning from the results.

The following is from a PTJ interview in the foreword of an updated Reminiscences of a Stock Operator edition:

In the book I think [Livermore] lost his entire fortune four or five times. I did the same thing but was fortunate enough to do it all in my early twenties on very small stakes of capital. I think I lost $10,000 when I was 22, and when I was 25 I lost about $50,000, which was all I had to my name. It felt like a fortune at the time. It was then that my father flew up from Memphis and sat me down in my tiny New York City apartment and began lecturing me as lawyers do. He commanded, “Leave the gambling den behind. Come home and get a real job in a safe profession like real estate.” Of course, I did not, and the rest is history…

The thing to fear, as the young PTJ knew, was not the risk of temporary small­-stakes capital loss for the sake of a learning curve… but the danger of a boring and unfulfilling life, having turned away from the trading game before the lessons clicked.

And thus, to the degree the experienced trader continues to dabble and play footsie with markets while fearing inconsequential things, he or she might miss the thing to REALLY fear… a loss of time that means a loss of learning and a loss of breakthrough… which means never graduating to the fulfillment of one’s potential. Just being a dabbler forever… an aphorism quoter on Twitter for all time.

Continuing with the Zhuangzhi breakdown:

Their words fly from their mouths like crossbow bolts, so sure are they that they know right from wrong. They cling to their positions as though they had sworn an oath, so sure are they of victory.

These traders are “sure” they know right from wrong (in terms of what trading success consists of). They are sure it is all contained in the trading commandments they have memorized, which they then repeat dutifully and often to everyone around them. (We all know the guy who tweets the same things over and over, day after day, ad infinitum…)

These traders “cling to their positions” of “knowing” the trading rules in the sense of never examining their rigid mindset ­­never stopping and saying “Wait… perhaps I am missing something crucial here…”

They keep the faith with religious fervor. And the net result is generally as follows (Zhuangzi again):

Their gradual decline is like autumn fading into winter ­­this is how they dwindle day by day. They drown in what they do ­­you cannot make them turn back. They begin to suffocate, as though sealed up in a box­­ this is how they decline into senility. And as their minds approach death, nothing can cause them to turn back to the light.

This is not the spectacular blow­up of the short vol seller. It’s a slow churning death of small loss after small loss. The slow bleed of thousands of trades with stops placed too close… and profits too meager to move any kind of needle.

There is no graduation, no transition to meaningful size­up, no scaling to a position of strength and fulfillment… no making the light worth the candle.

There is just playing around without building… tinkering without learning… churn without growth. It’s a sort of thin­gruel persistence… a stubborn surviving, and then a fading away.

In poker there is a saying attributed to the legendary Doyle Brunson: “Going out like Broomcorn’s Uncle.”

Nobody really ever figured out who Broomcorn’s Uncle is, but the saying refers to a poker player who is so meek and conservative he simply lets himself get anted to death. He takes nick after nick and cut after cut until finally his stack is chiseled down to oblivion, like the fading dwindlers of the Zhuangzhi passage.

It’s a strange thing. If a poker player goes out like Broomcorn’s Uncle, he was playing the game ­­sitting there at the table, engaging with opponents ­­but he wasn’t actually “playing the game.”

Instead that player becomes so focused on the mere aspect of surviving… the mere angle of not losing… that he lost sight of the fact that you need courage, guts, strategic vision, and the passion to step forth and exploit victory’s bold moments ­­if you choose to play the game in the first place.

There is a sort of rigor mortis that can set in for the hobbyist trader ­­set in their ways, set in their habits and set in their permanent biases. They’ve been trading for years, so they “know” all there is to know ­­or so they think­­ because the old truths are seen as be­all end­all, and years in the saddle give them license to be cranky.

Contemplating knowledge gaps becomes a less and less palatable thing over time, because that would require admitting that knowledge gaps exist. And so they harden… but never break through… and then finally fade.

How do you avoid this fate? In a nutshell, first by remembering that taking on risk ­­at the right time and place is the whole point of trading. If you are scared to ever go for the gusto, there was no point in entering markets in the first place. It’s good to survive and not blow up… but not if the follow-­on recipe is bread and thin gruel forever!

It’s hard to do that, of course. It’s hard to control risk most of the time, then press aggressively in the opportune windows. It’s hard to scale up in windows of true opportunity, while maintaining deep patience otherwise. But this hardness is a feature not a bug, because if it wasn’t damn hard there wouldn’t be so much profit in it!

Traders who have survived but not thrived have typically learned the basics of preserving their capital. The next hard lesson is learning how to push hard when it counts… how to make the light worth the candle via size.

This is how the legends like Stan Druckenmiller produced their outsized returns. They understood the concept of the big bet and when to swing hard. Druck’s words below:

The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

And there is just no easy way to learn that. No easy way. It CAN be learned, yes of course. But the learning of it is hard. It is a hard thing. And again this makes sense. If learning how to make big bets at the right time, while maintaining risk control properly, was an easy thing, then lots of people would do it. The reason only a small handful of traders pull it off is precisely BECAUSE OF the hardness and challenge of the path.

But the payoff for doing this ­­ for trying and succeeding ­­is far more than money. The pursuit itself sings to the practitioner’s soul, and as such the vitality of the adventurous trader’s spirit does not fade. Hunter S. Thompson:

Turn back the pages of history and see the men who have shaped the destiny of the world. Security was never theirs, but they lived rather than existed. Where would the world be if all men had sought security and not taken risks or gambled with their lives on the chance that, if they won, life would be different and richer? It is from the bystanders (who are in the vast majority) that we receive the propaganda that life is not worth living, that life is drudgery, that the ambitions of youth must he laid aside for a life which is but a painful wait for death. These are the ones who squeeze what excitement they can from life out of the imaginations and experiences of others through books and movies. These are the insignificant and forgotten men who preach conformity because it is all they know. These are the men who dream at night of what could have been, but who wake at dawn to take their places at the now-­familiar rut and to merely exist through another day. For them, the romance of life is long dead and they are forced to go through the years on a treadmill, cursing their existence, yet afraid to die because of the unknown which faces them after death. They lacked the only true courage: the kind which enables men to face the unknown regardless of the consequences.

As an afterthought, it seems hardly proper to write of life without once mentioning happiness; so we shall let the reader answer this question for himself: who is the happier man, he who has braved the storm of life and lived or he who has stayed securely on shore and merely existed?

 

Making Better Decisions

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Hey everybody.

Chris D here.

Last September, I gave a webinar to Macro Ops Collective members about my health habits and wellness practices. It’s an important topic because sloppy life practices away from the trading screens affect trading results way more than most people realize. Most of the questions and feedback I received from that video were about building trading systems and all the health and wellness that I focus on.

In this article I hope to provide you with health and wellness ideas that will up your trading game as well as your overall well being. After all, we don’t live solely to invest. We have family, friends, hobbies, and other projects in our lives that benefit from a focus on health.

My intention here is to share what has worked for me, for you to pick and choose what would benefit you the most, and then share with our team your tips and tricks.

Focus On Yourself First

Most think that it’s selfish to focus on your well being ahead of others you care about (ie, spouse, children). But, if you continuously sacrifice yourself for others and disregard your own mental and physical health, then what happens when that catches up to you and you’re sick, injured, or burnt out?

Something I learned in the military is a great metaphor for this. When I was younger, I was a United States Marine. An infantryman no less. The Marine Corps takes great pride in being a very self sufficient group, all the way down to the individual level. We are taught to take exceptional care of our weapons, our gear, ourselves and then it expands upward to our team, our squad, platoon, company, battalion, regiment and so on.

The Marine Corps traditionally arrive by sea. With that, we need to take care of our own. I was lucky enough to go through Combat Water Safety Swimmer (CWSS) training (basically lifeguard training on steroids) as part of my training.

During this training, we operate according to the standards and intensity expected of us in combat. All CWSS is carried out in boots, trousers, two shirts, body armor, helmet and rifle along with accompanying ammunition and gear that the normal Marine would wear during an amphibious landing.

A major objective of this training is learning how to rescue a drowning swimmer. This is done in full gear, with the victim in full gear too, while getting hit by ice cold waves. The task is made more difficult since the drowning swimmer is in full on survival mode. They’re fearing for their life and trying to grab onto anything, especially the rescuer.

In order to be a capable rescuer, you need to be a good swimmer, which gives you confidence in the water and provides confidence to the troubled swimmer you are rescuing. This is the most important (and dangerous) part about a rescue; the troubled swimmer isn’t  thinking logically, they are in fight or flight mode and very often you do end up in a fight. But our job is not to fight in the water our job is to rescue. We need to bring our rescuee back to reality, we need to calm them down, we need to give them a little confidence. This can take numerous attempts before you can get the swimmer to calm down enough to be rescued, as crazy as that might sound, and requires that you, as the rescuer remain calm, as well.

Applying this concept to real life: like that troubled swimmer, you won’t be able to help your family and friends when they need you the most if you aren’t taking care of yourself.

In order to take care of others (your spouse, family, friends, community and so on),  you need to be at your best or other people’s troubles will be like that drowning swimmer. If you’re weak, tired, and/or distracted, you put both yourself and those you are helping at risk of being pulled under.

To further emphasize this point, being a good trader/investor doesn’t just happen on a whim, after reading Twitter for months and subscribing to some newsletter. I argue it takes developing a process, focus, discipline, and many other things as well, but you must take care of yourself first.

Excellent decision making is hard. Good decision making is easier. But poor decision making is the easiest of all.

This is why I believe that in order to become successful, and maintain that success as an investor, the majority of the work needs to be done on yourself before you can makegood, and then excellent, decisions with your money and your life.

Treat Yourself Like A Professional Athlete

I’ve been trading and investing for a living for nearly 20 years now. There have been some very hard lessons learned along the way but it wasn’t until I realized that the real success in the markets comes from first working on myself.

As a former semi-professional athlete and someone who still trains quite a bit, I liken my mindset to that of a professional competitor. As an investor, our minds and bodies are the tools we use to get the job done.

(Check out how LeBron James approaches taking care of himself with training, diet and a major focus on recovery. I have a very similar approach, albeit not 7 figures!)

Let’s start with the subject of sleep.

Sleep

It wasn’t until 2018 that I realized how important sleep was to my health and focus, and the opportunity I had to jump-start my performance by just sleeping better.

Back to LeBron James…On the Tim Ferriss podcast, LeBron talks about getting 10 hours of sleep per night, and how he usually nap during the day as well.

This is an athlete playing a physically challenging sport, non-stop for six months at a time, and unlike many other professional basketball players, his season goes to the very last second of the very last game, as he is always in the championship. LeBron is still in his prime and he attributes a large amount of that to sleep.

For me, I always wore my 4AM wake up as a badge of honor, thriving on low amounts of sleep, and spending hours upon hours reading (usually about 8 hours before I really got going on the other things in my life).  While this definitely gave me a huge advantage and I benefited greatly from that discipline, and consumption of information, increasing my hours of sleep has significantly improved my ability to focus and to get into a desired mindset more quickly  and far more frequently than when I was operating on less sleep.

Here’s an interesting study and something I used to start my journey down the sleep “rabbit hole.”

“Brief periods of sleep loss have long-lasting consequences such as impaired memory consolidation.“

In the past I would go to sleep whenever I felt tired and wake up at 4AM regularly. I realized that focusing on the time I woke up was the key to getting more sleep. I force myself to stay in bed longer now, generally 5AM or6AM. I occasionally even find myself sleeping until 11AM – something old Chris would have never been able to do. Once I was able to overcome my 4AM wake up habit, making sure I received eight hours of sleep per night became easy. Now, I regularly get eight to ten hours of sleep every night.

Subjective results? Since then I’ve lost a bit of stubborn weight around the midsection, blew through some physical plateau’s and have built and improved my trading systems at a much faster and, more importantly, efficient tempo than ever before. I feel better, and I’m certain I make better decisions, so I continue.

Meditation

As soon as I wake up, immediately before looking at my phone, any screens, emails, texts, Instagram, charts, news or anything else, that might cause any thoughts, I go straight to meditation.

There is a surprising amount of noise in our minds as we sleep. The activity of dreaming, then switching directly to external feedback, or someone else’s agenda (news, social etc…), means that there is no time to switch context from what our subconscious mind was doing while we were sleeping, to the immediate barrage of stimuli.

Meditating immediately after waking can help organize those crazy subliminal suggestions and enables us to better get our sh*t in order before taking on the day.

I’ve been meditating for about 30 years now, pretty much everyday.

I was lucky enough to be taught it through sports when I was young and have taken that with me throughout my life. It wasn’t until this year that I discovered how much more effective and useful meditation is when you do it first thing in the morning.

Your mind will also thank you again for doing a second session in the afternoon, which I do as well, though not everyday. This can be in the form of a dedicated meditation session or cardio routine. When I’m in a city, I like to go for long walks; when I am in nature,  I like to hike, run trails or jog on the beach. The repetitive nature of hiking/jogging/walking helps me get into a meditative state.

While this s is subjective, meditating slows the world down for me. I make better decisions and am not bothered by things I can’t control when I am in a regular meditation practice. I am able to release worry and stress over these things.

Get Challenged By Nature

Challenging the elements further toughens the mind. I spend most winters in the snowy mountains so I get opportunities to be a part of some of the most extreme things that nature can offer. The strength I get from conquering the cold really sets the stage for my day.

During the winter after my morning meditation I throw my zero drop trail running boots on, a pair of shorts, and take a little morning jog…shirtless. There is something amazing about running in fresh powder snow with no sunlight and overcoming that voice saying that there is a nice warm shower back at home waiting for you, and continuing on.

This is about strengthening my mind, right along with meditation, this gives me the power to not be a victim of things that I can’t control. The cold is relentless but I can choose to not let it bother me.

Cold showers work too if you don’t have mountain access. In urban areas I like to spend about 5 minutes under cold water in the morning after I finish my meditation practice.

Coffee

This is the first thing, outside of water, that is going into my body. I want to ensure that I reap all the benefits that coffee offers, without any of the negative aspects. This means only the highest quality, organic coffee that I can get my hands on. I like Kion Coffee.

Coffee has some amazing benefits, but the wrong type of coffee can have some less than desirable effects. Poor storage, pesticides, mold, and many other factors come into play when dealing with low quality coffee. More importantly, not so good coffee makes me feel not so great…

I hand grind with this travel grinder and run it through my travel french press. Over the years I’ve traveled with different coffee accoutrement and I’ve found this to be my preferred setup.

That is the beginning of my morning routine, and how I start my day before I look at any charts, trades, emails, texts or anything else. When I do fire up the screens and get to work, I put a lot of effort into focusing at a high intensity.

Eliminate Distractions and Achieve Flow State

When I sit down at the computer to work, all notifications are completely removed: no ringers, no pop-ups, all sounds are turned off/muted. My phone goes on Do Not Disturb mode so I will not receive any phone calls unless it’s a family emergency.

Interruptions from Instagram, Twitter, texts, and calls can crush your productivity. The reason is context switching. Anytime you respond to a message, call, or notification you have to refocus your attention. This refocusing costs brain power and precious time. Don’t believe me? Here’s some research that shows how “expensive” context switching is on productivity.

To be in a headspace to make excellent decisions, I focus on doing one task at a time and doing it well. My goal is flow.

A great defense against the distractions from the outside world is a nice set of noise cancelling headphones. I currently use these Bose and Beats and I just pre-ordered these babies – which are supposed to rival the Bose for sound quality.

To get into the flow state, I shove some Binaural Beats into my ear holes based on the chosen mindset I’m intending to achieve. Binaural beats need to be listened to with headphones to have the desired effect, where each ear is played a different musical wavelength and the difference between the two in your brain is the wavelength you are attempting to stimulate. Non-lyrical repetitive music is even easier than going down the Binaural Beat path. Try classical baroque era music; I’ve found it to be useful. Looking for something different? There’s a reason that Trance music is called Trance music. Give it all a shot!

3, 2, 1, Go…

After all of my boxes are checked, (good night’s rest, meditation, cold exposure, high quality coffee, silenced notifications, binaural beats) it’s time to check charts, update trades, and double check my risk for the day.

The first 30 minutes of trading will tell me if I have a new setup or not. If so, I put everything together, entry, exits, position size, and then send off that information to my broker.

That’s the skinny on my morning routine. It has evolved a lot in just one year, and I expect it to continuously evolve as I discover and adopt new best practices, but so far this ritual has me dialed in, focused, and ready to make the best quality trading decisions day in and day out.

The Rest of The Day

There’s a lot more that goes into my daily routine after these morning rituals, but I will save my diet, exercise routine, trading systems, geeky technology thoughts, travel methods, and much more on the soon to be released Macro Ops Podcast!  

I’m happy to chat further about this in the Comm Center Slack where I spend most of my time or Tweeting @chrisdmacro or Insta @chrisdmacro Or hit me up at chris@macro-ops.com.

 

The Chandler Brothers: The Greatest Investors You’ve Never Heard of

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Two secretive brothers from New Zealand have perhaps THE best long-term track record in the investing world. Starting in 1986, the two turned $10 million of family money into over $5 billion just 20-years later. That’s an astounding 36% CAGR.

Compare that with Buffett (19% over 50yrs), Klarman (20% over 34yrs), Lynch (29% over 13yrs),  Soros and Druckenmiller both around (30% over 30yrs).

Yet, hardly anybody has ever heard of these guys. I live and breathe markets and I just came across them for the first time this year.

This is by design.

The two brothers have gone to great lengths over the years to maintain a low profile and keep their faces out of the news. It wasn’t until 2006 that they chose to give their first and only substantial interview. It was with Institutional Investor (link here), and they only agreed to the interview so they could counteract bad press they were receiving from Korean media over a failed activist push by the two to upseat management at a Korean Chaebol.

They were amongst the first investors to plunge into emerging markets like Russia, Brazil, and the Czech Republic. They are sons of a WWII veteran who ran a beekeeping business with Edmund Hillary (yes, that Edmund Hillary), before starting what became New Zealand’s most upscale department store.

They are perhaps THE MOST INTERESTING INVESTORS IN THE WORLD.

They are the Chandler brothers: Richard and Christopher. They ran the Sovereign Global Fund for 20-years (the two have since split off to manage their own money with Legatum and Clermont Capital).

To follow is a profile of the brothers along with some of the secrets they’ve shared in how they look at and invest in markets — also, some commentary and case studies of their investments by me. (All quotes are from the Institutional Investor interview unless otherwise noted).

First, some quick background on the brothers and their unusual origin story (emphasis by me).

The Chandler’s investing background is anything but conventional. The brothers grew up in Matangi, a rural town outside the provincial city of Hamilton in the dairy farming country of New Zealand’s north island. Their Chicago-born grandfather had emigrated to New Zealand in the early 1900s, gone into advertising and married his secretary. He died of an allergic reaction when his third son, Robert, was just one year old.

Although he never knew his father, Robert was profoundly marked by the American success literature he had left behind, notably the books of Orison Swett Marden, an early-20th-century American journalist and author who inspired such proponents of “positive thinking” as Dale Carnegie and Norman Vincent Peale. Robert’s sons were deeply influenced by this worldview as well. We are great believers in the idea of having audacious goals, breaking out and doing something out of the ordinary,” says Richard. “It’s helped us turn what most people consider a mere profession into a vocation and, beyond that, an art, where we frequently put ourselves in harm’s way.”

In 1972, Robert and his wife Marija, started a department store called the Chandler House which quickly became a booming business. This is where the two brothers, Richard and Christopher, began learning the skills of business and investing.

Richard and Marija employed their two sons at the store when not away at boarding school. The two worked sales and helped their father balance the books on the weekend. They also accompanied their mother on buying trips where they learned the key principles on how to buy right (more on this below).

Richard referred to his mother as “the most brilliant business person I’ve ever met who taught us many of the key principles we follow as investors”. Two of these key principles were, “Never buy something unless you know to whom you can sell it” and “Buy as much as possible in a narrow range of hot items.” Richard said his mother “was able to identify the best opportunities and be the master of narrow and deep and that, with stocks, we do the same thing. We back our beliefs to the hilt.

The two brothers were essentially getting an MBA when they were only kids. This undoubtedly helped shaped them into the two market masters they are today.

After college, Richard and Christopher took over the family business and rapidly expanded its size. And in 1986 they sold it for $10m which they then used to launch their fund Sovereign Global. Richard remarked on the decision to the sell the family business that, “Basically, we said, ‘Let’s do something that we love to do, not just something that we are good at.” That something they loved, was investing…  

The fund’s first investment serves as a perfect example of the style that would typify the brother’s approach. And that’s contrarian to the extreme and highly concentrated. Narrow and deep just like their mother taught them.

The two poured nearly the entire family fortune into just four Hong Kong office buildings in 1987.

That year the property market in Hong Kong was in dire straights. Real estate prices were down roughly 70% from their 81’ peaks. Britain’s lease on the territory was due to lapse in the coming decade and according to Richard, “The feeling was that China was going to take over Hong Kong, so most investors said, ‘Who cares?”.

The sentiment at the time was that the island was uninvestable. Here’s a few Newspaper headlines from the year.

This pervasive negative sentiment and over extrapolation of recent trends is what drew the two brothers to the place.

They objectively studied the fundamentals and came away with a variant perception. Richard remarked on the time that, “We had read the treaty, and it promised the status quo for 50 years, and we believed it. Even more important, rents were rising, and rental yields exceeded interest rates by 5 percentage points, which guaranteed that any investment would more than pay for its financing costs.”

The brothers leveraged up and paid $27.6 million for D’Aguilar Place, a 22-story building. They then renovated the place which allowed them to triple rents over just three years, which gave them the cash to acquire more buildings.

Low and behold, Hong Kong didn’t immediately become a communist despot as many feared. The property market recovered and the brothers sold their buildings for $110m, pocketing over $40m after paying off creditors; quadrupling their fund’s NAV in just over four years time.

The brothers also invested in Hong Kong stock index futures during this time which they viewed as another way to play the recovery in the property market, as the Hang Seng was mostly made up of real estate companies. But in the middle of the the crash of 87’ their stop losses were hit and the brother’s were forced to close out the position. The following week markets crashed around the world and the brother’s narrowly escaped a major loss.

Richard said they learned from this experience that “if you get lucky once, don’t press your luck.” It also gave the brothers an aversion to using leverage. Being unlevered “enabled the Chandlers to take a long-term view of risky markets, their key competitive advantage at a time when many investors, particularly highly leveraged hedge funds, invest with a short-term horizon.” A long-view is a critical part of their philosophy, as Richard notes the brothers “like investments where the risk is time, not price.”

With their recent winnings in Hong Kong the brothers went looking in emerging markets. Richard recalled that “The fax machine was becoming very popular” and “we felt that value was moving from real estate to communications. So we researched it and found that Telebras was the cheapest telecom company in the world.”

It was here that they ran into some analysis problems which led to them developing a unique valuation method which they would use again and again throughout their careers.

At the time, Brazil’s hyperinflation had rendered earnings and P/E ratios absolutely meaningless. So they had to turn to “creative metrics — in this case, market capitalization per access line. Telebras, the nation telephone monopoly, was trading at about $200 per line, compared with $2,000 for Mexico’s Teléfono de México and an average cost of $1,600 for installing a line in Brazil. The brothers bet that the government of then president Fernando Collor de Mello would liberalize the economy and open the country up to foreign investment.”

This practice of using unique metrics to compare and discern value is an important piece of what Richard calls “the ‘delta quadrant’ — transition economies or distressed sectors where information is not easily available and standard metrics don’t apply.”

After obtaining government permission to invest in Brazilian equities (Sovereign was one of the first foreign investors in the country) the brothers put $30m —  roughly 75% of their fund — into Telebras shares in 1991 and a smaller amount into Electrobras, an electric utility.

This was an even more contrarian bet than Hong Kong was. Not only was sentiment in the dumps in Brazil (news clipping from 91’ below) but foreign investors weren’t even looking at opportunities there. The Chandler brothers were walking their own path.

Once Collor de Mello began cutting the budget deficit and opening the market to foreigners, Brazilian equities tripled. But soon “Collor de Mello was… caught in a massive kickback scheme and was impeached that April. Stocks swooned, falling 60 percent over the next eight months. Most foreign investors fled the market, but the Chandlers sat tight.”

Richard recalls the selloff saying, “As far as we were concerned, the shock was external to the fundamentals of the company… Telebras had simply gone from extremely undervalued to outrageously undervalued.”

By 93’ the market recovered and the Chandlers sold out of their position later that year. The brothers more than 5x’d their initial investment in under 3-years, boosting their fund to more than $150m. Richard said the experience of riding out the volatility helped them “build our emotional muscles, helping us to make it through major market falls and grind through the trying times without losing our equilibrium.”

The brothers continued their run of highly concentrated and extremely contrarian investing with forays into Eastern Europe, South Korea, and Russia. Always going into markets and investing in assets that no one else would touch.

Another great example of their approach is their big bet on Japanese banks in the early 2000s. Institutional Investor writes that “In November 2002, with Japan slipping back into recession after a decade of stagnation and with stocks at 20-year lows — the Nikkei 225 index was more than 78 percent below its 1989 peak — the country’s banks were wallowing in bad debt.” It was under this backdrop that the Chandlers began loading up on shares in the sector.

The two bought a $570m stake in UFJ Holdings, “which had posted a staggering loss of $9.3 billion in its latest year. The pair went on to buy more than 3 percent of Mizuho Financial Group as well as stakes in Sumitomo Mitsui Banking Corp and Mitsubishi Tokyo Financial Group… Altogether they spent about $1 billion on their spree.”

“The banks were priced for a total wipeout of equity holders,” says Sovereign’s broker at the time at Nikko Citigroup, John Nicholis. “We were advising our clients to stay away from the sector.

Here’s a few headlines from the time showing the negative consensus of the time.

Like in Brazil, the brothers had to be creative in the metrics they used to value the banks since they didn’t have any “earnings on which to base multiples, and uncertainty about the extent of bad loans made it difficult to forecast a turnaround.”

So instead, the team looked at “market capitalization as a percentage of assets; on this daily basis they determined that UFJ and other megabanks traded at about 3 percent, compared with 15 percent for Citigroup at the time. The Chandlers concluded that Japan would have to nationalize the banks or reflate the economy with low interest rates, and bet — correctly, as it turns out — on the latter scenario.”

After riding out a near 50% decline from when they began building their position the Chandler brothers rode the stock all the way back up to new multi-year highs. They were still sitting in the stock in 2006 (when the II interview was conducted).

In talking about their big win in Japan, Richard said that, “Most fund managers are focused on what can go wrong rather than on what can go right and were too afraid to make that call. We were not.

Talk about having courage in your convictions. These guys must have to push around a wheelbarrow to haul their giant cojones around.

Richard helps shed light on how he and his brother are so effectively greedy when others are fearful in sharing one of his favorite sayings from Investor Philip Carret, who said it is essential “to seek facts diligently, advice never.” Richard explains: “Money managers have to account for their actions to their shareholders, which means they have an undue fear of underperformance. We invest only our own money. Our investment decisions are driven by optimism, not fear.

Once they establish the conviction they then have the optimism and courage to buy in size. II writes:

The brothers also prize scale, believing that the way to achieve outsize returns is to make a few big bets — Sovereign usually holds fewer than ten stocks — rather than manage a diverse portfolio. The Chandlers favor large-cap stocks in big countries. “If you are invested in big companies in big countries, that means there is a ready audience of benchmark-following investors who must buy the asset,” says Richard. “By buying big — going narrow and deep, as opposed to diversifying — you maximize your success.

Sovereign usually holds fewer than ten equity positions at any one time. Though it typically holds its larger positions for two to five years, the firm regularly trades in and out of some stocks to test the waters and take advantage of price movements.

It’s very important to note that this isn’t dumb blind conviction. You’re not a smart contrarian by just buying a hated falling asset. The crowd could be correct and the underlying could be worth much less than what it’s selling for.

The Chandlers lived and breathed business from the time they were children. Richard had a degree in accounting and a masters in Commercial studies. After college he worked for a big accounting firm where a coworker recounted his “incredible intellectual capacity and enormous, almost unbelievable thirst for knowledge. He used every project we work on as an experience to learn a new business model.”

These two know businesses. They know what’s important and the things to look for in valuing them. They know how to correctly assess a prospects margin of safety in relation to its upside.

Richard said, “Our talent is to understand the long-term potential of a business” and “the market gives you the opportunity to arbitrage what the emotional investor will pay or sell at versus the fundamental value of a company, but you’ve got to pull the trigger promptly without hesitating… We’ve disciplined ourselves mentally and prepared ourselves in terms of information, as well as relationships with brokers, to do that.”

Lessons From the Chandler Brothers

To make these types of long-term outsize returns, you have to go NARROW and DEEP.

That means putting large portions of your portfolio into just a few high conviction trades, the veritable fat pitches, when they come along.

We call this Fat-Tail Exploitation Theory, or FET for short. And it flys in the face of all the conventional wisdom that espouses the wonders of diversification. Druckenmiller talked about the importance of FET when he said the following:

The first thing I heard when I got in the business, from my mentor, was bulls make money, bears make money, and pigs get slaughtered.

I’m here to tell you I was a pig.

And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

And Barton Briggs touched on it in his book Hedgehogging when writing about his friend and macro fund manager, Tim.

To get really big long-term returns, you have to be a pig and ride your winners… When he lacks conviction, he reduces his leverage and takes off his bets. He describes this as “staying close to shore… When I asked him how he got his investment ideas, at first he was at a loss. Then, after thinking about it, he said that the trick was to accumulate over time a knowledge base. Then, out of the blue, some event or new piece of information triggers a thought process, and suddenly you have discovered an investment opportunity. You can’t force it. You have to be patient and wait for the light to go on. If it doesn’t go on, “Stay close to shore.”

A reason why FET is key to delivering outsized returns is because of the underlying power laws that are embedded in markets. Pareto’s law of 80/20, or in markets it’s more like 90/10 or 95/5 even, which means that 90% of your returns will come from 10% or fewer of your trades.

Just take a look at the profile of Sovereign’s returns. Over a 15-year period just five investments generated 90% of their returns (chart via II).

There are two keys to this.

One is that you can’t force it and you have to really really know your stuff or else you’re assuming blind risk and opening yourself up to financial ruin. The Chandler brothers understand businesses inside and out. They could cut through the fluff in laser like fashion and get to the meat of the issue when evaluating companies.

Second is time. Fat pitches like these don’t come around often. The Chandlers would go years in between big investments without risking any substantial amount of money. Michelangelo once said that, “Genius is infinite patience” well the corollary to that in investing is that infinite patience is success.

Joel Greenblatt said this about the need for patience and taking a big picture view of things:

Legg Mason’s Bill Miller calls it time arbitrage. That means looking further out than anybody else does. All of these companies have short-term problems, and potentially some of them have long-term problems. But everyone knows what the problems are.

Next there is contrarianism.

The Chandler brothers made it a point to set up shop in Dubai and Singapore, far away from the financial centers of the world in New York and London. They did this because they didn’t want to fall victim to the powerful pull of groupthink and herd mentality.

Being able to look at the same situation as the market and form a variant perception lies at the heart of how they uncover highly asymmetric trades. A good way to develop a variant perception is to take a page from the Palindrome, George Soros, who said:

The generally accepted view is that markets are always right — that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite view. I believe the market prices are always wrong in the sense that they present a biased view of the future.

As humans we all have the tendency to get wrapped up in the hysteria and be seduced by compelling narratives, especially when the components of fear or greed are present. But it’s in these situations where the narrative has driven the market to extrapolate trends ad infinitum, driving prices to ridiculous levels, that create the environment where amazingly asymmetric bets exist.

You need to step back, objectively sift through the data yourself, and develop a big picture view of things. This is what Templeton referred to as “the point of maximum pessimism” which Bill Miller explains here:

The securities we typically analyze are those that reflect the behavioral anomalies arising from largely emotional reactions to events. In the broadest sense, those securities reflect low expectations of future value creation, usually arising from either macroeconomic or microeconomic events or fears. Our research efforts are oriented toward determining whether a large gap exists between those low embedded expectations and the likely intrinsic value of the security. The ideal security is one that exhibits what Sir John Templeton referred to as “the point of maximum pessimism.”

And lastly, you need to be creative and think out of the box in order to form a variant perception and see a future different from the one in which the crowd is pricing in.

The Chandler brothers used “creative metrics” and the point is that it’s not rocket science. But it does mean you need to do the thinking, do the work, and come to your own conclusions. Great opportunities aren’t found in a simple screen or low P/E. They exist BECAUSE they are difficult to find, to comprehend, to value. Greenblatt says it like this:

Explain the big picture. Your predecessors (MBAs) failed over a long period of time. It has nothing to do about their ability to do a spreadsheet. It has more to do with the big picture. I focus on the big picture. Think of the logic, not just the formula.

Narrow and Deep. Contrarian. And think of the logic, not just the formula…

 

 

My Notes on the Druckenmiller Real Vision Interview

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Alex here.

The Druckenmiller Real Vision interview is well worth the watch if you have a subscription and 90 minutes to spare. And if you don’t, you’re in luck because I’m sharing with you my notes along with some of my thoughts on what the GOAT said.

Let’s begin…

The start of the interview was by far my favorite part and really blew me away.

Stanley Druckenmiller opened the conversation by looking straight into the screen and then spoke some words I’ll never forget. He said, “Alex Barrow, I am your real biological father…” My jaw dropped even though this was something I’ve always kind of suspected. I mean, just look at the photo of me and my dog below. The resemblance is pretty uncanny. It’s nice to finally know the truth for certain.

Now that I’m done showing off my photoshopping skills, let’s get to the real stuff.

13D founder, Kiril Sokoloff, leads the interview and he and Druck discuss a wide range of topics including his views on the current macro environment, the diminishing signal of price action due to the rise of algorithmic trading, central bank policy, and then my favorite which was his thoughts on trade and portfolio management.

Here’s Druck talking about the difficulty he’s been having in this low rate environment, and how he’s made the vast majority of his money in bear markets (with emphasis by me).

Yeah, well, since free money was instituted, I have really struggled. I haven’t had any down years since I started the family office, but thank you for quoting the 30-year record. I don’t even know how I did that when I look back and I look at today. But I probably made about 70% of my money during that time in currencies and bonds, and that’s been pretty much squished and become a very challenging area, both of them, as a profit center.

So while I started in equities, and that was my bread and butter on my first three or four years in the business, I evolved in other areas. And it’s a little bit of back to the future, the last eight or nine years, where I’ve had to refocus on the equity market. And I also have bear-itis, because I made– my highest absolute returns were all in bear markets. I think my average return in bear markets was well over 50%. So I’ve had a bearish bias, and I’ve been way too cautious the last, say, five or six years. And this year is no exception.

It’s no secret the central bank suppressed rate environment has hurt practitioners of old school macro, such as Druck and PTJ. When these guys began their careers they could park their money in 2-year rates and capture high single to double-digit rates.

Not only did this jack up their returns but higher interest rates and inflation caused more volatility and action in markets. And exploiting volatility is the lifeblood of old school macro traders. Like Druck said, he made his highest returns during bear markets.

The last decade of extremely low-interest rates and dovish Fed policy has suppressed volatility, leading to smoother trend paths. This has led to more capital flowing into passive indexing and less to active managers, which in itself helps to extend the trend of less volatile markets; at least to a point.

Eventually, this low rate regime will reverse. We’ll see higher inflation and a secular rise in interest rates. In fact, this is one my highest conviction ideas for the next secular cycle. The massive debt and unfunded obligations in developed markets, along with the secular rise in populism, nearly ensures that we’ll see profligate government spending and competitive devaluations in the decade ahead.

So we’ll see the rise of volatility and an environment conducive to old school macro once again!

Here’s Druck discussing the major macro thematics he’s been tracking this year.

I came into the year with a very, very challenging puzzle, which is rates are too low worldwide.

You have negative real rates. And yet you have balance sheets being expanded by central banks, at the time, of a trillion dollars a year, which I knew by the end of this year was going to go to zero because the US was obviously going to go from printing money and QE to letting $50 billion a month, starting actually this month, runoff on the balance sheet. I figured Europe, which is doing $30 billion euros a month, would go to zero.

So the question to me was, if you go from $1 trillion in central bank buying a year to zero, and you get that rate of change all happening within a 12-month period, does that not matter if global rates are still what I would call inappropriate for the circumstances? And those circumstances you have outlined perfectly. You pretty much have had robust global growth, with massive fiscal stimulus in the United States, where the unemployment rate is below 4. If you came down from Mars, you would probably guess the Fed funds rate would be 4 or 5/ and you have a president screaming because it’s at 175.

I, maybe because I have a bearish bias, kind of had this scenario that the first half would be fine, but then by July, August, you’d start to discount the shrinking of the balance sheet. I just didn’t see how that rate of change would not be a challenge for equities, other than PEs, and that’s because margins are at an all-time record. We’re at the top of the valuation on any measures you look, except against interest rates. And at least for two or three months, I’ve been dead wrong.

So that was sort of the overwhelming macro view. Interestingly, some of the things that tend to happen early in a monetary tightening are responding to the QE shrinkage. And that’s obviously, as you’ve cited, emerging markets.

We talked about this obvious market mispricing in our latest MIR, The Kuhn Cycle (Revisited). The old narrative of low rates for longer had become extremely entrenched. And this narrative consensus has created a certain amount of data blindness, as is typical with popular and enduring narratives. This data blindness has led to a large mispricing of interest rates, particularly in developed markets.

Where things get interesting is all the corollaries that stem from a low rate narrative like this. Think of the billions of dollars that have poured into private equity over the last decade. The current PE model is predicated on the assumption of interest rates staying low, which is needed for their businesses’ long-term funding needs and justification for their sky-high valuations etc…

A really interesting section of the interview is when Druck talks about the diminishing signaling value in price action. He says:

The other thing that happened two or three months ago, mysteriously, my retail and staple shorts, that have just been fantastic relative to my tech longs, just have had this miraculous recovery. And I’ve also struggled mightily– and this is really concerning to me. It’s about the most trouble I’ve been about my future as a money manager maybe ever is what you mentioned– the canceling of price signals.

But it’s not just the central banks. If it was just the central banks, I could deal with that. But one of my strengths over the years was having deep respect for the markets and using the markets to predict the economy, and particularly using internal groups within the market to make predictions. And I think I was always open-minded enough and had enough humility that if those signals challenged my opinion, I went back to the drawing board and made sure things weren’t changing.

There are some great nuggets in here. I’ve long thought that one of the most important skill sets of a great trader — and something Druck has in spades — is to be extremely flexible mentally; never marrying oneself to a viewpoint or thesis and continuously testing hypotheses against the price action of the market.

Market Wizard Bruce Kovner said he owed much of his success to this, saying:

One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what the world should be like and wait for one of them to be confirmed. You keep trying them on one at a time. Inevitably, most of these pictures will turn out to be wrong — that is, only a few elements of the picture may prove correct. But then, all of a sudden, you will find that in one picture, nine out of ten elements click. That scenario then becomes your image of the world reality.

And Livermore noted the importance of flexibility when he wrote, “As I said before, a man does not have to marry one side of the market till death do them part.”

Now compare this to the “Fintwit experts” who have peddled a doom and gloom outlook for the last 7 years without ever taking a step back to maybe rejigger the models they use to view the world, which have been so consistently wrong.

Anyways, Druck then goes on to lay out the cause behind the diminishing power of price signals.

These algos have taken all the rhythm out of the market and have become extremely confusing to me. And when you take away price action versus news from someone who’s used price action news as their major disciplinary tool for 35 years, it’s tough, and it’s become very tough. I don’t know where this is all going. If it continues, I’m not going to return to 30% a year any time soon, not that I think I might not anyway, but one can always dream when the free money ends, we’ll go back to a normal macro trading environment.

The challenge for me is these groups that used to send me signals, it doesn’t mean anything anymore. I gave one example this year. So the pharmaceuticals, which you would think are the most predictable earning streams out there– so there shouldn’t be a lot of movement one way or the other– from January to May, they were massive underperformers. In the old days, I’d look at that relative strength and I’ll go, this group is a disaster. OK. Trump’s making some noises about drug price in the background.

But they clearly had chart patterns and relative patterns that suggest this group’s a real problem. They were the worst group of any I follow from January to May, and with no change in news and with no change in Trump’s narrative, and, if anything, an acceleration in the US economy, which should put them more toward the back of the bus than the front of the bus because they don’t need a strong economy.

They have now been about the best group from May until now. And I could give you 15 other examples. And that’s the kind of stuff that didn’t used to happen. And that’s the major challenge of the algos for me, not what you’re talking about.

Well, I’ll just, again, tell you why it’s so challenging for me. A lot of my style is you build a thesis, hopefully one that no one else has built; you sort of put some positions on; and then when the thesis starts to evolve, and people get on and you see the momentum start to change in your favor, then you really go for it. You pile into the trade. It’s what my former partner George Soros was so good at. We call it– if you follow baseball, it’s a slugging percentage, as opposed to batting average.

Well, a lot of these algos apparently are based on standard deviation models. So just when you would think you’re supposed to pile on and lift off, their models must tell them, because you’re three standard deviations from where you’re supposed to be, they come in with these massive programs that go against the beginning of the trend. And if you really believe in yourself, it’s an opportunity. But if you’re a guy that uses price signals and price action versus news, it makes you question your scenario.

So they all have many, many different schemes they use, and different factors that go in. And if there’s one thing I’ve learned, currencies probably being the most obvious, every 15 or 20 years, there is regime change. So currency is traded on current account until Reagan came in and then they traded on interest differentials. And about five years, 10 years ago, they started trading on risk-on, risk-off. And a lot of these algos are built on historical models. And I think a lot of their factors are inappropriate because they’re missing– they’re in an old regime as opposed to a new regime, and the world keeps changing. But they’re very disruptive if price action versus news is a big part of your process, like it is for me.

If you’ve been trading for any significant amount of time then you’ve certainly noticed the change in market action and tone due to the rise of algorithmic trading over the last decade. There’s often little rhyme or reason behind large inter-market moves anymore. Moves can simply happen because, as Druck said, algos that run on standard deviation models determine one sector has advanced too much relative to another, so the computers start buying one and sell another.

What we can do as traders now is to evolve and adapt. Work to understand what the popular models are that drive these algos so we can understand when they’re likely to buy and sell.

Also, I love his line about how he works to build a thesis and a position when he says:

A lot of my style is you build a thesis. Hopefully, one that no one else has built; you sort of put some positions on; and then when the thesis starts to evolve, and people get on and you see the momentum start to change in your favor, then you really go for it. You pile into the trade.

This a great lesson in trade management and how to build into a position using the market as a signal.

Druck also talked about Google (one of our largest positions) and reveals how he looks at some of the tech stocks that are popularly thought of as “overvalued” by the market.

I guess, let’s just take Google, OK, which is the new bad boy, and they’re really a bad boy because they didn’t show up at the hearing. They had an empty chair because they only wanted to send their lawyer.

But it’s 20 times earnings. It’s probably 15 times earnings after cash, but let’s just say it’s 20 times. Let’s forget all that other stuff. And they’re under earning in all these areas, and losing money they could turn it off. And then I look at Campbell’s Soup and this stuff selling at 20 times earnings.

And they’re the leaders in AI– unquestioned leaders in AI. There’s no one close. They look like they’re the leaders in driverless car. And then they just have this unbelievable search machine. And one gets emotional when they own stocks, when they keep hearing about how horrible they are for consumers.

I wish everyone that says that would have to use a Yahoo search engine. I’m 65, and I’m not too clever, and every once in a while, I hit the wrong button and my PC moves me into Yahoo. And Jerry Yang’s a close friend so I hate to say this, but these things are so bad.

And to hear the woman from Denmark say that the proof that Google is a monopoly and that iPhones don’t compete with Android is that everyone uses the Google search engine is just nonsense. You’re one click away from any other search engine.

I just I wish that woman would have to use a non-Google search engine for a year– just, OK, fine, you hate Google? Don’t use their product, because it’s a wonderful product. But clearly, they are monopolies. Clearly, there should be some regulation. But at 20 times earnings and a lot of bright prospects, I can’t make myself sell them yet.

Kiril then asks Druck about portfolio construction and how he builds positions, which was one of my favorite parts of the interview.

Kiril: When you worked with Soros for 12 years, one of the things that you said you learned was to focus on capital preservation and taking a really big bet, and that many money managers make all their money on two or three ideas and they have 40 stocks or 40 assets in their portfolio.

And it’s that concentration that has worked. Maybe you could go into that a bit more, how that works, how many of those concentrated bets did work, when you decided to get out if it didn’t work, do you add when the momentum goes up assuming the algos don’t interfere with it?

Druck: As the disclaimer, if you’re going to make a bet like that, it has to be in a very liquid market, even better if it’s a liquid market that trades 24 hours a day. So most of those bets, for me, invariably would end up being in the bond and currency markets because I could change my mind. But I’ve seen guys like Buffett and Carl Icahn do it in the equity markets. I’ve just never had the trust in my own analytical ability to go in an illiquid instrument, which in equity is if you’re going to bet that kind of size on– you just have to be right.

But to answer your question, I’ll get a thesis. And I don’t really– I like to buy not in the zero inning and maybe not in the first inning, but no later than the second inning. And I don’t really want to pile on in the third or fourth or fifth inning.

But even against the dollar, it’s not all-in right away. Normally, I’ll wait for– I’ll go in with, say, a third of a position and then wait for price confirmation. And when I get that, when I get a technical signal, I go.

I had another very close experience with the success of the Deutschmark, which was the euro. I can’t remember– I think it was 2014 when the thing was at 140, and they went to negative interest rates. It was very clear they were going to trash that currency, and the whole world was long the euro. And it would go on for years. I’d like to say I did it all at 139, and I did a whole lot, but I got a lot more brave when it went through to 135. And that’s a more normal pattern for me.

We write a lot about the importance of concentrating your bets due to the natural power law distribution of returns (here’s a link).

This part of the interview was great because it shows how Druck uses a confluence of factors to leg into a trade. He says he develops a theory then waits for the market to begin to validate that theory and he puts a small (usually ⅓ position on). He then waits for further market confirmation that he’s correct (he calls this point the second inning) at which time he piles in and goes for the jugular.

The chart below illustrates perfectly his short EURUSD trade.

Here’s Druck talking about the 2000 tech bubble and what made him turn bearish.

Then there would be this strange case of 2000, which is kind of my favorite, and involves some kind of luck. I had quit Quantum, and Duquesne was down 15%. And I had given up on the year and I went away for four months, and I didn’t see a financial newspaper. I didn’t see anything.

So I come back, and to my astonishment, the NASDAQ has rallied back almost to the high, but some other things have happened– the price of oil is going up, the dollar is going way up, and interest rates were going up— since I was on my sabbatical. And I knew that, normally, this particular cocktail had always been negative for earnings in the US economy. So I then went about calling 50 of my clients– they stayed with me during my sabbatical– who are all small businessmen. I didn’t really have institutional clients. I had all these little businessmen. And every one of them said their business was terrible.

So I’m thinking, this is interesting. And the two-year is yielding 6.04, not that I would remember, and Fed funds were 6 and 1/2. So I start buying very large positions in two and five-year US treasuries. Then, I explained my thesis to Ed Hyman, and I thought that was the end of it. And three days later, he’s run regression analysis– with the dollar interest rates and oil, what happens to S&P earnings? And it spit out, a year later, S&P earnings should be down 25%, and the street had them up 18.

So I keep buying these treasuries, and Greenspan keeps giving these hawkish speeches, and they have a bias to tighten. And I’m almost getting angry. And every time, he gives a speech, I keep buying more and more and more. And that turned out to be one of the best bets I ever made. And again, there was no price movement, I just had such a fundamental belief. So sometimes it’s price, sometimes it’s just such a belief in the fundamentals.

Higher oil, higher dollar, and higher interest rates is likely to eventually lead to a negative earnings surprise for us as well; though that’s probably at least a few quarters if not further away.

Kiril then asks Druck about how he manages a drawdown. What he does emotionally and practically to stage a comeback.

Kiril: One of the great things I understand you do is when you’ve had a down year, normally a fund manager would want to get aggressive to win it back. And what you’ve told me you do, you take a lot of little bets that won’t hurt you until you get back to breakeven. It makes a tremendous amount of sense. Maybe you could just explore that a little bit with me.

Druck: Yeah, one of the lucky things was the way my industry prices is you price– at the end of the year, you take a percentage of whatever profit you made for that year. So at the end of the year, psychologically and financially, you reset to zero. Last year’s profits are yesterday’s news.

So I would always be a crazy person when I was down end of the year, but I know, because I like to gamble, that in Las Vegas, 90% of the people that go there lose. And the odds are only 33 to 32 against you in most of the big games, so how can 90% lose? It’s because they want to go home and brag that they won money. So when they’re winning and they’re hot, they’re very, very cautious. And when they’re cold and losing money, they’re betting big because they want to go home and tell their wife or their friends they made money, which is completely irrational.

And this is important, because I don’t think anyone has ever said it before. One of my most important jobs as a money manager was to understand whether I was hot or cold. Life goes in streaks. And like a hitter in baseball, sometimes a money manager is seeing the ball, and sometimes they’re not. And if you’re managing money, you must know whether you’re cold or hot. And in my opinion, when you’re cold, you should be trying for bunts. You shouldn’t be swinging for the fences. You’ve got to get back into a rhythm.

So that’s pretty much how I operated. If I was down, I had not earned the right to play big. And the little bets you’re talking about were simply on to tell me, had I re-established the rhythm and was I starting to make hits again? The example I gave you of the Treasury bet in 2000 is a total violation of that, which shows you how much conviction I had. So this dominates my thinking, but if a once-in-a-lifetime opportunity comes along, you can’t sit there and go, oh well, I have not earned the right.

Now, I will also say that was after a four-month break. My mind was fresh. My mind was clean. And I will go to my grave believing if I hadn’t taken that sabbatical, I would have never seen that in September, and I would have never made that bet. It’s because I had been freed up and I didn’t need to be hitting singles because I came back, and it was clear, and I was fresh, and so it was like the beginning of the season. So I wasn’t hitting bad yet. I had flushed that all out. But it is really, really important if you’re a money manager to know when you’re seeing the ball. It’s a huge function of success or failure. Huge.

This is perhaps the most important section of the interview. So much of being a great trader is learning to arbitrage time and I mean that in a number of different ways.

First, it means to analyze things on a longer timescale, to be able to pull back and look at the bigger picture, the broader trends, and not get hung up on a missed earnings or the latest news cycle. And secondly, it’s to have enough experience to be able to trust your process to the point that you know returns will eventually come to you if you just stick to your game. This form of time arbitrage means that you’re focusing on having a good return record over a 3, 5, and 10 year time period and you won’t go full-tilt if you’re down for a quarter.

Capital preservation always comes first and a strict adherence to a solid process produces good outcomes over the long pull.

That’s it for my notes. I tried to include all the sections that I thought were worth sharing though I’m sure I missed some stuff. Watch the interview yourself if you can. Here’s a snapshot of Quantum Funds returns; Druck took over in 88’.

 

 

The Psychology Behind Managing A 20 Bagger…

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What do you do with a massively profitable trade that has grown to become a large percentage of your total portfolio value?

This question has been circulating in the Macro Ops Collective chat room the last few weeks because one of our deep out of the money (DOTM) calls took off in a big way. Back in the summer we bought call options on AMD struck at 28 for $0.40. Those calls traded as high as $8.50 in the month of September — a 2000% gain.

Managing large winners like this is difficult… really difficult. The reason being is that there’s no universally correct answer.

Managing losing trades is pretty straight forward. You define the risk before you enter and once the asset hits your stop, you exit. Easy peasy.

Winners are a whole other animal. Now you’re faced with the question of: Do I let my winner keep running and risk giving some or all of my profits back or do I take profits now foregoing more upside but putting cash in hand? This is literally one of the toughest questions in trading and something we at MO are constantly stewing on.

A winning DOTM option magnifies this conflict because of how volatile they become once they go in the money. A DOTM option can easily lose 30-50% of its value in a day if the stock pulls back after an extended run.

Another difficulty with a profitable DOTM option is that as it becomes more in the money, the reward-to-risk payout structure shifts from a highly convex one to being more linear.

When a stock crosses the strike of a DOTM call the options have usually already appreciated by 10x-20x. At this point, the forward reward-to-risk drastically changes. Instead of risking 1 unit to make 10 or 20, you’re now risking 10-20 units of unrealized profit for a potential gain of another 10-20. So instead of a 10:1 reward-to-risk in your favor, it becomes a 1:1 proposition.

After mulling this over for awhile with the other members of the Macro Ops Collective we think the profit taking decision comes down to these two things.

  1. The size of the unrealized profit relative to your net worth
  2. Your portfolio performance optimization strategy

You may think a DOTM call option will go on to appreciate from a 20 to a 40 bagger. But, what’s really important is whether you have the psychological makeup that will allow you to actually hold through the inevitable volatility and realize that second tranche of gains.

Your ability to hold through the volatility without tapping out is dependent on the size of the position relative to your net worth. This is also why managing large winners is so difficult. Since everyone has their own unique risk tolerances, there’s no “one size fits all” advice.

Picture these two scenarios:

Scenario 1: Bob puts $10,000 in a DOTM call that turns into $200,000. He has a net worth of $500,000.

Scenario 2: Jane puts $10,000 in a DOTM call that turns into $200,000. She has a net worth of $5 million…

Which of these two traders will have an easier time pressing and holding their winner?

Obviously, Jane will, because Bob’s going to feel it right in the gut if he gives back half those gains (20% of his net worth) to the market. It will bother Jane too, but will be much less mentally trying.

The larger the position is relative to your net worth the more mentally taxing it is to hold onto.

It’s painful to watch large paper gains swing up and down by double digit amounts on a weekly basis — which is exactly what can happen if you hold onto a DOTM call option that has 20x’d but still has many months until expiration.

Only a small fraction of traders have the stomach for holding onto large winners like these that have become a large percentage of their total portfolio values. Operator Darrin pointed this out during our conversations in the Comm Center. He correctly states that this ability is partially hereditary.

I’ve been lucky to know some real traders w/ what I’d call “Market Wizard DNA”. One, just made an additional 2mm dollars on LULU overnight (post earnings). I only bring this up because I think this insight can offer clarity for new traders/investors…

This trader was in a drawdown for 6-months that was > -30%. He held conviction in this trade (long gamma, long dated) for almost a year. It was his largest holding. He analyzed the fundies, the vol term structure etc…

At the point in which the trade started to yield some strong profits, he held on. We are talking .03 delta —>.50 delta kind of profits. Yet, he continued to hold on. The moral of the story is that 95% of humans do not have the ability to actually execute at this level.

I meet so many smart quantitative analysts and traders, yet I know that almost none of them have the behavioral edge necessary to reap the benefits of triple digits even four digit returns—and that’s perfectly ok!

I say all of this to remind retail traders that it’s ok to be average. It’s ok if a 20% return on 100k is the best you can do. The financial media have done everyone a disservice. They omit the part of the Big Short where they held losing options for YEARS before getting rich.

I can only speak for my own experience, but the biggest difference between the market wizards and everyone else is probably DNA. They have an ability to take risks on large sums of money that the average person could never imagine. That’s a major edge…probably the biggest edge available.

Having the wherewithal to endure large account swings is not for most of us which is why the correct answer for the majority of traders is to take profits when faced with massive unrealized gains.

Now let’s talk about portfolio performance optimization. This comes into play if the winner is small enough so that it’s not an emotional burden. For example, if a trader put 25 basis points (bps) into a DOTM option that goes on to 20x, that is still only a 5% account appreciation. At this position size the trader can think with his prefrontal cortex instead of his dumb lizard brain (limbic system).

Different traders need to optimize for different things. Some people just want to straight up maximize returns. Others need to prioritize consistent performance, especially those who are managing other people’s money or looking to raise funds.

Traders and investors who need their account balance to help pay for things outside of the market are also operating in a shorter timeframe and generally would rather have consistency and smoothness of returns rather than higher but much more volatile ones.

Taking profits sooner on large winners will pull performance forward in time, reduce account volatility and create a smoother equity curve. But it also sacrifices long-term return potential in the process…

Traders with true long-term capital and the psychological fortitude to ride out massive profit volatility should hold and press large winning trades because that will compound capital at the highest rate in the long run.

The biggest mistake we see with traders who decide to hold their winners is that they are optimizing for the long run even though they aren’t managing true long-term capital. Most people underestimate what it takes to apply a disciplined process day in and day out for a decade. And a decade is the bare minimum we would consider long-term.

If you want to see how we ended up managing our 20x winner on AMD you’re in luck because Tyler will be talking about it in our free DOTM webinar this Thursday, October 4th at 9PM EST.

Click this link to sign up for the Macro Ops DOTM special event!

Tyler will be presenting all the specifics of our DOTM option strategy and how we used it to produce a 2000% gainer on AMD. He’ll also be discussing our year-to-date performance for the DOTM plays, the winners and the losers. You don’t want to miss this.

If you have any interest in our DOTM option strategy that has produced 2000% returns, sign up now at the link below!

Click this link to sign up for the Macro Ops DOTM special event!

 

 

How To Implement Cheap Black Swan Protection

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The following is a guest post from Kim Klaiman, full time options trader and founder of steadyoptions.com.

Introduction

The earnings season provides a lot of opportunities for active options traders. Some traders like to play earnings with directional bets, buying straight calls or puts. This is a very tough strategy. You have too many factors playing against you. Even if you are correct about direction, you need to overcome the Implied Volatility (IV) collapse that usually comes after earnings are announced.

Others play it with non directional strategies like straddles or calendars, but hold the trades through earnings. Those strategies can definitely work, but they could also be very volatile due to unpredictability of earnings.

Personally, I prefer to play earnings non-directionally. One of my favorite strategies is buying a straddle a few days before earnings and closing the position before the announcement to reduce the risk.

How straddles make or lose money

A straddle is a vega positive, gamma positive and theta negative trade. What does it mean?

  1. The theta is your enemy: all other factors equal, the trade will be losing value due to time decay.
  2. The vega is your friend: increase in IV (Implied Volatility) will help the trade.
  3. The gamma is your friend as well: stock movement in any direction will help the trade.

The straddle makes money as follows: The stock has to move (no matter which direction) and/or the IV (Implied Volatility) has to increase.

A straddle works based on the premise that both call and put options have unlimited profit potential but limited loss.

While one leg of the straddle losses up to its limit, the other leg continues to gain as long as the underlying stock rises or falls, resulting in an overall profit. When the stock moves, one of the options will gain value faster than the other option will lose, so the overall trade will make money. If this happens, the trade can be closed before expiration for a profit.

You execute a straddle trade by simultaneously buying the call and the put. You can leg in by buying calls and puts separately, but it will expose you to directional risk. For example, if both calls and puts are worth $5, you can buy a straddle for $10. If you buy the call first, you become bullish — if the stock moves down, the calls you own will decrease in value, but the puts will be more expensive to buy.

This is how the P/L chart looks like for a straddle:

When to use a straddle

Straddles are a good strategy to pursue if you believe that a stock’s price will move significantly, but unsure as to which direction. Another case is if you believe that IV of the options will increase — for example, before a significant event like earnings. IV usually increases sharply a few days before earnings, and the increase should compensate for the negative theta. If the stock moves before earnings, the position can be sold for a profit or rolled to new strikes. This is one of my favorite strategies that we use in our model portfolio for consistent gains.

Many traders like to buy straddles before earnings and hold them through earnings hoping for a big move. While it can work in some cases, I don’t do it. The reason is that over time the options tend to overprice the potential post earnings move. Those options experience a huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move. This is the reason why we will always close those trades before earnings for whatever P/L we can get. There will be some rare exceptions, but in general, this is the rule.

How straddles can serve as a cheap black swan protection

I like to trade pre-earnings straddles/strangles for several reasons. There are three possible scenarios:

  1. The IV increase is not enough to offset the negative theta and the stock doesn’t move. In this case the trade will probably be a small loser. However, since the theta will be at least partially offset by the rising IV, the loss is likely to be in the 7-10% range. It is very unlikely to lose more than 10-15% on those trades if held 2-5 days.
  2. The IV increase offsets the negative theta and the stock doesn’t move. In this case, depending on the size of the IV increase, the gains are likely to be in the 5-20% range. In some rare cases, the IV increase will be dramatic enough to produce 30-40% gains.
  3. The IV goes up followed by the stock movement. This is where the strategy really shines. It could bring a few very significant winners. For example, when Google moved 7% in the first few days of July 2011, a strangle produced a 178% gain. In the same cycle, Apple’s 3% move was enough to produce a 102% gain. In August 2011 when VIX jumped from 20 to 45 in a few days, I had a Disney strangle and a few other trades more than double.

During broad market corrections, you can have very nice gains, as a result of both stock movement and IV increase. So the losses are usually very small, the winning percentage is around 70%+ and you get cheap black swan protection.

Here is just one example using the August 2011 meltdown.

Walt Disney (DIS) was scheduled to report earnings on August 9, 2011. With the stock trading at 37.30, you could buy a 38/36 strangle with expiration at August 19, 2011, ten days after earnings.

The P/L chart would look like this:

Fast forward to the next Monday, August 8, 2011:

That’s right, after the market was down double digits, the strangle value almost tripled.

Of course those huge gains are not common. You need a severe market correction to get them. But for a strategy that produces stable 7-10% gains with very low risk, having this black swan protection in the portfolio is a huge added value.

Profit Target and Stop Loss

My typical profit target on straddles is 10-15%. I might increase it in more volatile markets. I usually don’t set a stop loss on a straddle. The reason is that the upcoming earnings will usually set a floor under the price of the straddle. Typically those trade don’t lose more than 5-10%.

The biggest risk of those trades is pre-announcement. If a company pre-announces earnings before the planned date, the IV of the options will collapse and the straddle can be a big loser. However, pre-announcement usually means that the results will be not as expected, which in most cases causes the stock to move. So most of the time, the loss will not be too high, especially if there is still more than two weeks to expiration. But this is a risk that needs to be considered.

Summary

Earnings straddles can be a good strategy under certain circumstances. However, be aware that if nothing happens in term of stock movement or IV change, the straddle will bleed money as you approach expiration. It should be used carefully, but when used correctly, it can be very profitable, without the need to guess the stock direction.

Kim Klaiman is a full time Options Trader and founder of steadyoptions.com – options education and trade ideas, earnings trades and non-directional options strategies. Read more from Kim on his Options Trading Blog.

 

 

The Human Trader’s Secret Weapon

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Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot. ~ Joel Greenblatt

Investing is hard.

It’s a game of relative comparisons. We have limited capital and nearly unlimited opportunities to deploy it. Our job then as traders/investors (I use the terms interchangeably but will use investor from here on out) is to use our tools to sift through the thousands of stocks, bonds, and currencies to pick and select the handful of assets we think will give us a higher return than the market. This is obviously no easy feat…

The question we get from readers more than any other is about the framework we use to identify these asymmetric opportunities. They want to know how to sift through all the noise and numbers and find the stocks that are going to make them money!

A big piece of this puzzle is by first defining what exactly it is you’re looking for so you’ll know it when you see it. Once you’ve defined it, you can create a framework and process for identifying it. Then rinse and repeat…

That’s what we’re going to do in this month’s report. We’re going to discuss the different classifications of equity investing opportunities and then focus on our favorite, that of the long-term compounder. We’ll walk you through the first principles of value investing and then go through the step-by-step process of our framework for identifying stocks with massive long-term compounding potential.

You may be asking, aren’t you guys macro traders? Why are you writing about fundamental value investing?

That’s a fair question… You see, the key point about being a macro trader is that we’re not constrained by a rigid and narrow approach to markets. Our sole guiding philosophy is to make high risk-adjusted returns using whatever means necessary.

This is a flexible and opportunistic approach. We care only about positive asymmetry and not about what tools or mental frameworks (ie, technicals, fundamentals, classical macro etc…) we need to use to find them.

In reality, nearly every investment includes some combination of different factors and drivers. The best trades are the ones where the entire Marcus Trifecta of technicals, sentiment, and fundamentals align together in a fat pitch setup.

Like a warrior going into battle we don’t see the utility in limiting ourselves to a single weapon or style of fighting. Similar to Bruce Lee’s Jeet Kune Do, we aim to use anything and everything that works to help us win.

Value investing and understanding how to discover and identify long-term compounders is an essential tool in the macro trader’s toolkit. And that’s what we’re going to give you a master class in today. We’ll conclude by using this framework to analyze two stocks that we believe have long-term multibagger potential.

And hopefully after reading this report you’ll never feel like you’re running through a dynamite factory with a burning match again…

Breaking it down to the principle level

I believe there are an infinite number of laws of the universe and that all progress or dreams achieved come from operating in a way that’s consistent with them. These laws and the principles of how to operate in harmony with them have always existed. We were given these laws by nature. Man didn’t and can’t make them up. He can only hope to understand them and use them to get what he wants. ~ Ray Dalio

Every investing framework and process we build needs to be built upon clear, simple, and universal principles. Let’s discuss what some of these are.

An investor can have any combination of the following three edges:

  1. Informational: They can be privy to information that the market is not; through proprietary data (ie, using satellites to track foot traffic at stores) or by extreme due diligence in less watched areas of the market (really digging into the micro cap space) or by less scrupulous methods (insider knowledge).
  2. Analytical: They can look at the same data but come to different and superior conclusions through greater due diligence and/or better frameworks for understanding the world.
  3. Behavioral: They have better understanding and control of their own nature and thus exploit behavioral anomalies that arise in markets largely due to short-term emotional overreactions.

We briefly touched upon in last week’s note how the informational advantage has largely been arbed away due to the wide scale availability of powerful quantitative tools and screeners and information dissemination in general. At least for the retail investor, who doesn’t have access to proprietary credit card and store receipt data, and can’t plug into their satellite that’s tracking Walmart North American store traffic, they are left with the final two edges of analytical and behavioral — we can use this fact to our advantage.

The talented hedge fund manager and value investor Scott Miller said recently in an interview that he welcomes the proliferation of quantitative investing, remarking (emphasis mine):

I actually want quantitative strategies to proliferate. I want money to pile into them, gobs and gobs of it. The more money into quant strategies the better, as I think they are likely to create distortions that I can take advantage of over time. You can have your backward looking quantitative data and use that for the foundation of your decisions. I would rather understand the product, market, and management team of the companies I am investing in.  

We agree with Scott.

Our analytical edge needs to be in seeing the same data but assembling the pieces differently, in the hopes of creating a truer representation of the underlying business and its intrinsic value.

Joel Greenblatt often mentioned in his investing class at Columbia that he believed he was only average at valuation work (he had little edge there), but where he excelled — where his edge lay — came in being able to put the information together in context; view things from the bigger picture and pinpoint the factors that really mattered.

He was quoted as saying:

Explain the big picture. Your predecessors (MBAs) failed over a long period of time. It has nothing to do about their ability to do a spreadsheet. It has more to do with the big picture. I focus on the big picture. Think of the logic, not just the formula.

He only had access to the information everyone else had but he was able to piece it together to come to a completely different and more true conclusion — develop a variant perception. This is what an analytical edge is.

So we know that our value investing framework needs to include mental models for viewing and interpreting data in a more useful way. It needs to help give us a variant perception of reality and strengthen our analytical edge.

There are a number of ways to think about the behavioral edge. One being the emotionally driven overreactions to certain events (could be a missed earnings, negative press, or a broader market selloff) that create large valuation gaps. Long-time hedge fund manager, Bill Miller, puts it like this:

The securities we typically analyze are those that reflect the behavioral anomalies arising from largely emotional reactions to events. In the broadest sense, those securities reflect low expectations of future value creation, usually arising from either macroeconomic or microeconomic events or fears. Our research efforts are oriented toward determining whether a large gap exists between those low embedded expectations and the likely intrinsic value of the security. The ideal security is one that exhibits what Sir John Templeton referred to as “the point of maximum pessimism.”

Which brings us to another foundational principle about value investing: The best value investments will always have a well articulated and very convincing logic as to why they’re priced the way they are. These bearish arguments will always be predicated on a certain amount of truth. It’s this convincing narrative that creates the large mispricing. The thing is, these narratives tend to build on themselves. As they become more popular they tend to extrapolate the negative data points on which they’re built, further and further out the left tail, driving the price lower and further away from probable outcomes.

And like Howard Marks likes to say, there’s no such thing as a good or bad stock just good or bad prices.

A value investor must use their analytical edge to develop a variant perception in order to capitalize off the market’s behavioral overreaction.

Another aspect of behavioral edge is one of timeframe. The market which is becoming increasingly quantitatively focused has gotten very good at predicting earnings 1 to 2 quarters out. But with this short-term quantitative edge, comes the loss of long-term context and so the players in the market have become more and more myopic and short-term focused.

This trend towards market myopia widens the behavioral edge for those willing to peer a little further into the future and play the long game in their investing. This is a kind of time arbitrage that allows a patient investor to capitalize on the market’s broader short-termism.

To turn back to Bill Miller who said this about time arbitrage:

For the market broadly, the recent trends are toward shorter investing time horizons and less active stock selection, which gives us confidence in our competitive advantages of long-term, actively managed investing. The average holding period for mutual funds is now down to just six months, compared to our time horizon of three to five years. We believe that the one constant in the markets is the behaviors of groups of people and the advantages provided by a focus of behavior inefficiencies. The broad features of human behavior have not changed, and social psychologists have mapped pretty well how large numbers of people behave under various conditions. We try to arbitrage between perception and reality in behavior.

Our value investing framework needs to capitalize on our behavioral edge by objectively exploiting market overreactions — letting the fundamentals dictate our actions and not be reactive to short-term price moves —  and arbitraging time by peering further into the future and being more patient with our investments.

And so we have some clear foundational principles on which our framework can be built. We need to:

  • Utilize an analytical edge to arrive at a variant perception.
  • Exploit behavioral driven market overreactions that result in large mispricings.
  • Arbitrage time by playing the long game of peering further into the future and practicing infinite patience.

Moving on…

In our quest to further define what it is we’re looking for we can bucket equity investments into two broad categories:

    1. Macro: These are trades where the primary driver of returns is from macro inputs and not due to individual stock specifics. Cyclical commodity stocks fall under this category where their returns are driven by the capital cycle and the price of the underlying commodity. Market timing and sentiment driven trades also fall under this category.
  1. Fundamental Value:  These trades are primarily driven by the conditions and valuation of the underlying company. Fundamental value trades can be bucketed further into three separate categories.
      1. Classic value: These are the deep value sum of the part investments and the classic Graham net-net plays where the investment thesis rests on the mispricing of the company’s current intrinsic valuation; a valuation which depends less on the company’s future growth and more on the price given to its current assets and earnings stream.  
      1. Special situation: These are Joel Greenblatt style anomalous mispricings caused by spinoffs or a host of other reasons. These aren’t typically long-term plays but are held until the valuation gap caused by an event is closed.
    1. Long-term compounders: These are the real money makers. These are the special stocks that grow in value exponentially over long periods of time. They are run by skilled capital allocators, typically with large amounts of skin in the game, and are companies with wide moats that allow for enduring returns above the cost of capital.

These graphs below from Hayden Capital show the different intrinsic value growth curves and stock price path.

It’s the graph over on the right hand side where we want to focus the majority of our time and which we’re going to discuss today.

Long-term compounders are the stocks that can create generational wealth — if held on to. The problem is that they can be difficult to identify a priori but that’s what we’re going to solve for today.

First, let’s start with a simple math exercise from Scott Miller that shows the incredible power of compounding.

Example:  We underestimate the power of compounding and the impact of difference in return rates over a long period of time.

Question: What is the difference in ending capital between $100K that grows at 10% for 30 years vs. $100K that grows at 20% for 30 years?

Answer: $21M+

10% -> $1,744,940

20% -> $23,373,631

$21M+ dollars is quite a lot from just a 10% difference in annual returns over a long period. George Soros and Stanley Druckenmiller are both worth billions of dollars because they compounded money at an average of 30% return over decades!

This brings us to another foundational principle in markets and the people who play in them:

Humans are inherently bad at understanding the scale of exponential growth and the power of compounding…

We’re linear creatures who think in logarithmic terms. But if we want to harness the 90/10 distribution of market returns and put the power of compounding to work then we need to think in and seek out exponential growth opportunities for our capital.

Investing in a long-term compounder is essentially like allocating your capital to a compounding wizard like Druck or Soros. You can think of these companies almost as the best private equity firms, but ones with access to niche markets and the best information and deal flow available; along with an appropriate incentive structure that creates the opportunity for extraordinary alpha.

William Thorndike’s excellent book The Outsiders is a case study of the 8 best long-term compounders and the operators who ran them. Below are graphs to show the difference in returns over long periods of time that identifying and investing in a long-term compounder, an Outsider stock, can provide.

The differences in return outcomes are extraordinary… they’re exponential…

The market’s inability to properly comprehend and analyze exponential growth is one of our biggest analytical edges. It’s the reason why you have many self proclaimed “value” guys shorting high growth stocks — stocks with super high ROICs — and essentially throwing themselves on the burning pyre as sacrificial lambs because they’re doing linear math in a geometric world *cough Einhorn cough*…

Hopefully, you now get my point about the power of long-term compounding and exponential growth and how finding these stocks can be life changing. Understanding the power of compound growth and factoring that into your value analysis makes for a big analytical edge.

The Principle of Bubble Rotation

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In the book Business cycles: history, theory and investment reality, the author Lars Tvede talks briefly about a cycle phenomenon he calls The Principle of Bubble Rotation. He writes:

There is one further common aspect of all these asset classes. We have seen that business cycles from time to time create monetary environments that are conductive to asset bubbles. However, people will recall past crashes for a while, and this means that whatever asset people bought in the last bubble will rarely be chosen for the next. This leads to a systematic bubble rotation. There was a bubble in precious metals/diamonds in 1980, for instance, and then in collectibles (and Japanese land) in 1990, and then in equities in 2000.

Essentially, what Lars is saying boils down to, “what outperformed in the last cycle will not outperform in the next.”

Since trading and investing is a game of comparisons, we evaluate all assets on a relative basis and then choose to buy one thing over another. Using The Principle of Bubble Rotation we can underweight assets/sectors/industries that may look attractive at first glance but are unlikely to outperform for the simple reason that they did so in the prior cycle.

Let’s look at the outperformers from the last cycle and see how they’ve done in the current one.

The top performing assets/sectors/industries in the 02’ to 08’ cycle were:

  • Emerging markets
  • Homebuilders
  • Financials
  • Commodities

So far each of these assets/sectors/industries have adhered to The Principle of Bubble Rotation.

The reasons why this cycle skip exists are three fold:

  1. Psychological: Investors who were burned buying into a bubble in the previous cycle are likely to be hesitant to buy into those same assets in the next. We call these “event echoes” where the psychological scarring from a jarring market event affects investor behavior well into the future. This usually takes two cycles to reset because most investing careers don’t last much longer than that.
  2. Capital Cycle: Asset bubbles are born from overoptimism. This optimism attracts capital and competition which leads to large amounts of capital expenditure into future supply. This leads to over-capacity which takes the subsequent cycle to clear.
  3. Regulatory: There’s a regulatory cycle that is always fighting the last war and which typically goes into motion following the bust process where many investors were hurt or financial instability occurred. Take banks following the GFC or cryptos following the current bust process as an example. These regulations typically take the completion of another cycle before deregulation occurs.

The Principle of Bubble Rotation isn’t a hard and fast rule. There’s examples where it didn’t hold true and certain industries are susceptible to their own unique capital cycles which affect the length of their boom/bust process.

Still, it’s a useful heuristic to use for filtering down your universe of potential trades. It would have kept you from buying financials this cycle, which has been a popular but dead money trade. Also, it would have alerted you to areas of the market that were more likely to outperform since they underperformed in the previous cycle; the technology sector being a perfect example.

 

 

Probabilities Not Predictions

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Markets are context dependent, their behavior is a function of the particular circumstances that exist and how those circumstances are expected to or do change. The trick is not to predict an unknowable future, but to try to understand the present and the probabilities of the various paths that may evolve from it. ~ Bill Miller

We often write that we’re not in the business of making predictions. Rather, our job is to gauge the asymmetry of outcomes.

We do this by determining what the consensus beliefs and positioning are by triangulating the macro, sentiment, and technicals. This helps us paint a picture of what expectations are already embedded in the price. Then we just weight these against possible future paths.

The larger the disparity between consensus and potential outcomes, the greater the asymmetry and the more attractive the bet (trade).

There are additional benefits to using this mental model versus the typical one of making predictions.

  1. It helps protect you from yourself. Certainty is a killer in this game. When we play the prediction game, we put ourselves at risk of becoming champions to a cause and slipping into the pull of our ego driven tribal nature. This distorts our perception of the world and blinds us to new information.
  2. Prediction making is linear and bimodal in nature. Markets are non-linear and endlessly dynamic. This fact causes prediction makers to live in friction and disharmony with markets — think the perma bears who’ve been on the wrong side of the market for years. They become stuck when their view of the world does not match up with how things actually are.
  3. Focusing on asymmetry of outcomes versus predictions frees the speculator from the psychologically destructive game of trying to be right over wrong. Instead, the speculator lives in a world of various shades of grey (50 shades maybe?) where they’re always some mix of both right and wrong. In this way, the objective becomes not to form an opinion and stick with it. But rather, to apply Bayesian analysis and continuously update their views as new information comes in — this puts the focus on making money versus being right.

Bennett Goodspeed put it like this, “Why do investment professionals get such poor marks? The main reason is that they are victims of their own methodology. By making a science out of an art, they are opting to be precisely wrong rather than generally correct.”

This year, we’ve been more generally correct than we’ve been generally wrong. We’ve handedly beaten the market, as a result.

But we can’t rest on our laurels. We must constantly check for holes in our own assumptions. Like a good writer, we must be willing to kill our darlings and be ready to flip our positioning should the triangulation of the macro, sentiment, and technicals tell us to do so.

Yield Curve Inversion!? Flattening Yield Curve Explained

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The Yield Curve Inversion Secrets! Understanding the Flattening Yield Curve is crucial for any trader or investor!

Today we’re going to talk about the yield curve. Recently the financial media has been raving about the yield curve getting closer and closer to inverting and how it’s a signal that a recession is right around the corner. In this video we’re going to go over what the yield curve is, how to use it, and what it’s really signalling about the market.

The yield curve is basically just a line that plots the yield of US treasury bonds (TLT) with different maturity dates. The curve lets you easily compare rates on short term bonds versus long term bonds. When long term bonds are yielding more than short term bonds, the line rises from left to right. And when this is the case, it’s called a normal yield curve. This is signal that the economy and market are doing okay.

When you start to see the yield curve flatten or even invert, meaning short-term rates become equal to or higher than long-term rates, and the line either becomes flat or sloped lower from left to right, then that usually signals trouble ahead in terms of a recession and lower market prices.

Two things happen for the yield curve to become like this. First, the Fed starts raising short-term rates. Based on their mandates, they may see the economy overheating and decide to raise rates to slow it down. Higher rates hurt economic expansions.

Second, investor expectations for the future become negative. And because of that, they buy up long-term bonds, lowering their yield. Those two together you a flat or inverted yield curve where short term bonds yield the same or even more than long-term bonds. And like this signals trouble ahead.

According to our analysis, yes the curve is beginning to flatten and invert, but we still have a lot of time left before this bull iis done. Make sure to watch the video above for more!

And as always, stay Fallible investors!