It's About Time

Ecclesiastes 3:1-10

January 31, 2004

1 There is an appointed time for everything. And there is a time for every event under heaven-- 2 A time to give birth and a time to die; A time to plant and a time to uproot what is planted. 3 A time to kill and a time to heal; A time to tear down and a time to build up. 4 A time to weep and a time to laugh; A time to mourn and a time to dance. 5 A time to throw stones and a time to gather stones; A time to embrace and a time to shun embracing. 6 A time to search and a time to give up as lost; A time to keep and a time to throw away. 7 A time to tear apart and a time to sew together; A time to be silent and a time to speak. 8 A time to love and a time to hate; A time for war and a time for peace. 9 What profit is there to the worker from that in which he toils? 10 I have seen the task which God has given the sons of men with which to occupy themselves. The purpose at hand is capital preservation. The popular models for understanding the investment world are out of date. Current culture demands that the most complex situations be reduced to sound bites of a few seconds, and answers are obvious or they are not answers. It’s easier to shoot the messenger rather than evaluate the message. This behavior is not conducive to great investment results, and will likely wreak havoc on the majority of investors. The situation is worsened by the lack of integrity of our marketplace. Truth has become irrelevant and values are all relative. The anchor bias of the marketplace begins with the aphorism “the more things change, the more things stay the same”. It’s a bias rooted in the natural human error of oversimplification and an innate desire to shun issues of magnitude that defy quantification. While investment markets have always been full of change, clinging to the notion that everything is still the same is naïve and dangerous. The correlation of decision processes within the world’s largest investors (U.S. Pension Funds) has now reached a level where the market impact can be devastating. Their concurrent grasp for income or growth, for liquidity or private equity, has become a source of return similar to the baby boomers’ impact on homes and cars in the 50’s, growth stocks in the 60’s, hard assets in the 70’s, junk bonds in the 80’s, and tech stocks in the 90’s. Correlated behavior not based on rational economics is essentially momentum investing and drives roller coaster returns. Long-term investors risk extinction if they don’t apply more attention to the ramifications of their decisions. Relative value investing could be described as decision by indecision. The majority of investors accepts market valuation as a democratic process (the infamous Buffet voting machine) and therefore must be a true indicator of value. A close analysis of the ballot and ballot box indicates that market values are driven by popularity contests not logical economics. Popularity is less driven by consistent sequential earnings growth and more by brand recognition or significant earnings surprises. The overwhelming desire to be “popular” is now systematically driving decisions to a shorter and shorter investment horizon. “Systematically” includes the preponderance of CEO compensation based on stock performance with no income statement consequences. It includes Wall Street’s market cap based allocation of resources so the larger a stock’s market cap becomes the more investment worthy it is, therefore more analysts can follow it and recommend it, and more salesmen can sell it, and more advisors can buy it, and this makes it more “attractive”. This artificial feeding of liquidity desires has created a false sense of security and debased the integrity of our markets. Another systematic driver is the abundant reliance on mathematic modeling strategies that only partially reflect reality. Program trading is one such manifestation of these models and such programs now provide over 40% of the trading volume in the market. As models beget more models and robots essentially take over the execution of transactions integral to our economic

lives we enter a spectrum of risk that is not quantifiable. It is the difference between unlimited downside and unlimited upside. Too big to fail? Tell that to the passengers in the Titanic. Investment consultants near and far will advise their clients over the next few months and quarters that they have studied the markets, the sector returns, the investment funds available, and have decided that the optimal portfolio is X. X is perfect because it offers the best risk adjusted return of all the portfolio samples in the database. Many rules have been established to guide this recommendation such as length of track record, requirements for full investment, adherence to style and market capitalization guidelines, consistent management resources, position size and liquidity, etc. The notion that perhaps that whole particular universe is the wrong the place to be cannot be discussed because of other rules, i.e. no market timing, maintain appropriate (i.e. maximum) diversification, avoid tax erosion, etc. Careful observers of history recognize that markets based on unfair trading, corrupt middlemen, or irrational pricing ultimately implode with far reaching consequences. This may have the greatest impact on the latest darling of Wall Street – Hedge funds and Families of Hedge Funds. The tremendous demand for short-term performance has brought intense focus to the hedge fund industry. This marketplace of investment return is a result more of balancing acts and intellectual gymnastics, and while often of Olympic quality is still dependent on the quality of the arena. The arena we now know has a leaky roof, inadequate judges, and so many me-too competitors that long term results are unreliable for issues of survivor bias (50% of hedge funds started five years ago are not in business today). If and when this becomes recognized as an overcrowded, overpriced marketplace, the stampede for the exit may well destroy the whole herd. We are creatures of habit. We resist change in our homeostasis. This natural tilt affects our ability to evaluate risk and return, and causes us to look where the light is, instead of where it is not. As the search lights of the SEC and Elliot Spitzer have shown, Wall Street has dropped guidelines of protecting the investor in favor of protecting their lucrative middleman turf bringing to sharp focus the real risks to an individual’s capital. It’s about time. Keynes said it best, “in the long run, we are all dead”. We must manage our lives and investments for a reasonable investment horizon. We don’t drive cars focused on the hood ornament and we shouldn’t manage our capital focused on the next quarter’s results. The current obsession with short-term results may reflect an overwrought concern for control. The concern was bred from exercising no control in the last tech bubble, and so market participants may have jumped from the frying pan into the fire. As for me, I believe we must return to investments where capital is preserved through growth that is organic or overwhelmingly obvious. This can be accomplished in various ways, notably in timber, real estate, and wireless communications among others. Appropriate investment choices will generate cash flow, protection from inflation, and value within a deflation. As U.S. based investors we are entering a period of significant uncertainty where investment errors are magnified, and investment successes much more difficult to predict.