In our Weekly reading list this week, you will definitely find things off the beaten path. There are some excellent pieces on investing foundations from the impacts of time horizons (by a giant in academic finance), to probabilistic thinking and forecasting perceptions. We also take a look at China, which is becoming an ever stronger competitor in the global economy (psssst, they have to because their cost advantages are dwindling and they cannot afford to lose market share…). Finally, the Fed and its decision this week to begin shrinking its balance sheet. The more we look at the market impacts of the Fed’s reduction of support, the more we believe this will be material to prices. Why, because in truth, Central Bank policy has supported much of the market’s ability to absorb near term shocks and keep corporate margins high (something else you’ll read about this week!). With that, we leave you to it.
Here is a curated list of important stories outside the main headlines that caught our attention this week.
Long-Term Investing (Jack Treynor via the CFA Institute). This is a good article written by a giant in the field of academic finance, in support of the idea that long-term investing is a potentially valuable strategy that can exist even in a world of market efficiency. He describes two types of investments, one straight-forward and one which requires skill and judgement. For the former, a long-term investor has no “edge,” but the latter does give rise to an advantage over time. Treynor’s argument is based on a correct forecast of earnings, but I would submit that it holds true for understanding the growth of cash flows in general. In my experience, most investors tend to extrapolate current growth conditions into perpetuity, so having a more refined view of long-term growth offers the same benefits that Treynor describes. This article also includes one of my favorite quote from John Maynard Keynes: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
How China is battling ever more intensely in world markets (The Economist). A few short years ago, Chinese manufacturers were producing stuffed toys and metal zippers. Now Chinese companies produce sophisticated equipment and machines that compete with those from the US and Europe and many, in business and in politics, are crying foul. This article – which links to several other interesting article, looks at China’s strategies – some of which are frankly not very seemly – to become wealthy before it becomes old.
Yellen Sees QE as a Tool of the Future But Her Successor May Not (Bloomberg) One of the main topics of discussion at the Grant’s Interest Rate Observer conference Erik attended this spring was the likely effects of the US beginning to reverse its crisis-era stimulus policy of Quantitative Easing. The speakers who opined on this topic were not sanguine about the risks. On September 20, the Federal Reserve announced, almost as an afterthought, that it would begin to reverse QE policies, gradually at first. The Fed will begin its actions in October and will end 2017 by simply not rolling the government and agency debt it holds when it matures. Will the super geniuses who spoke at the Grant’s Conference be proven correct in their circumspection, or will their worries prove baseless? We think there will likely be a ripple in markets, if only because of market participants’ anticipation of lowered liquidity, but are not basing any investment decisions on this outlook.
Profit Margins, Bayes’ Theorem, and the Dangers of Overconfidence (posted to PhilosophicalEconomics.com on September 4). This is a long piece, but it is worth your time reading it because many value investors, including me, dealt with the very line of thinking this writer walks through from 2010 through the present. Over that period, looking at the total market, a value driven investor had to face the fact that corporate profit margins looked high compared to history and that there existed material risks to those margin levels persisting. Without them, I reasoned, values (and eventually, prices) would fall. So, I held cash. The author addresses this belief and the probabilistic thinking that would have helped me to overcome it. He also addresses over-confidence and the impact it can have on our willingness to accept data or ask questions that might cause a rethink of our position. Spend time with this one and think about your own process. It will help us to be more aware and that makes us better.
Heads, I win! Tails, You forget we had a bet…(Dan Gardner @ Slate.com) This is a super piece on how our media treats forecasting. Since we spend a bunch of time thinking about revenue and demand development out into the future in our valuation process, being a “good” forecaster is important. But how does our media deal with forecasters. Well, it turns out that survivorship bias reigns here. We laud the forecasts that come true and tend to forget about the ones that flop. So, when someone has been seen to properly forecast an outcome, such as the Michael Moore example in the article, we hyper focus on the quality of the forecast that has proven true and ignore all the ones that failed around it, even those that contradicted the one that came to pass! As investors, it’s really important to sort SIGNAL from NOISE and most of what you read about in terms of forecasting skill, isn’t. For more on this, revisit our article on the Superforecasters and forecasting.