Investing in The Unknowable: Red Flags and Opportunities

July 3, 2011

Low 1 High

Psychological versus

Value Pricing

THE FAT SEAGULL— The Current Salience of Behavioral Finance

100%

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Panic Euphoria

Housing 2007Stock MarketNovember 2008

Price/Value Ratio Relative to History or Recent Norms

Price/Value Ratio

Fat-Tailed Distribution

Frequency

Mr. Market

Powerful, Trickster, Readily Able to Change Shape

Old rules do not apply, at least while Loki remains in his trickster mode:

Mechanism: Investors respond to past market behavior. That transforms the nature of market behavior.

Regulating Finance

The MeltdownA Grey Swan

Subtle warnings were there

Lightning Bolt or Earthquake • Lightning bolt – Out of the blue, unforeseeable.

• Earthquake – Pressure builds up in a fault line. Finally slips. Great damage done.

• New paradigm –

• Immense volatility

– Interconnectedness among markets (psychological and real)

– Negative sentiment seems to presage falling not rising market.

– Individual stock selection may pay.

• Critical questions:

– Will momentum continue to be an explanatory factor?

– Will small investors come back to equities?

– Has volatility moved to a new level?

– Can trust in major financial institutions be restored?– Reputational externalities.

Real Asset (Housing) Real Asset (Housing)

Transparent Derivatives

Opaque Derivatives

Effective Rating Mechanisms Flawed Rating Mechanisms

Excessive LeverageReasonable Leverage

Effective Government Bailout (Liquidity, Confidence) Impotent Government Bailout

Rock Bottom Recovery

The Market Rolls Down

API302-EE-2008-10-30

European Markets Moved Down with Dow Jones

*DowJones, AEX and DAX indexed to January 3rd, 2007 = 100, VIX not indexed**CBOE Volatility Index

Source:EuroNext, Yahoo! Finance, Ojobo Atukulu, Ronald Roosdorp, Christoph Schwerdtfeger

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AEX

DowJones

DAX

VIX**

Weekly Averages, Indexed Values*

Jan 2007 Jan 2008 Oct 2008

Metaphor for Market Slide

• At every table. Each person picks a number from 1 to 100.

• If all numbers at a table are 50 or over, each person gets $10.

• If any number at a table is under 50:

• Any player 50 or over gets $2.

• Any player under 50 gets $8.

Red Flags Before the Meltdown 1. Transparency is not certain. You do not know earnings. You

do not know risks.2. Experts are fooled. You will be fooled.3. Bubble in one market implies bubble in many markets.

Bubbles are contagious.4. Treating bubbles alike. Housing bubble worse than NASDAQ

bubble. Much greater penetration to real economy.5. Finance executives Keeping Up with the Joneses.6. Failure to trace contagion of risks. RJZ recognizing subprime,

missing AIG.7. Financial termites.

Red Flags After the Meltdown

8. Earthquake. Old wisdom may not apply.9. People asking about the bottom. Statistically very

unlikely to be picked.10. Small losses of value – fundamentals matter. Large

losses of value – Keynes beauty contest and the fun-house mirror.

11. You feel a need for a short-term investment.

Gaining Reassurance Without Reason Quotations from the Great Depression

Recovery?

Date DJIA Quotation

September 1929 381 "There is no cause to worry. The high tide of prosperity will continue." – Andrew W. Mellon, Secretary of the Treasury.

October 14, 1929 351

"Secretary Lamont and officials of the Commerce Department today denied rumors that a severe depression in business and industrial activity was impending, which had been based on a mistaken interpretation of a review of industrial and credit conditions issued earlier in the day by the Federal Reserve Board." – New York Times

December 5, 1929 251 "The Government's business is in sound condition." – Andrew W. Mellon, Secretary of the Treasury

December 28, 1929 238

"Maintenance of a general high level of business in the United States during December was reviewed today by Robert P. Lamont, Secretary of Commerce, as an indication that American industry had reached a point where a break in New York stock prices does not necessarily mean a national depression." – Associated Press dispatch.

January 13, 1930 250 "Reports to the Department of Commerce indicate that business is in a satisfactory condition, Secretary Lamont said today." – News item.

January 21, 1930 250

"Definite signs that business and industry have turned the corner from the temporary period of emergency that followed deflation of the speculative market were seen today by President Hoover. The President said the reports to the Cabinet showed the tide of employment had changed in the right direction." – News dispatch from Washington.

January 24, 1930 256 "Trade recovery now complete President told. Business survey conference reports industry has progressed by own power. No Stimulants Needed! Progress in all lines by the early spring forecast." – New York Herald Tribune.

March 8, 1930 275 "President Hoover predicted today that the worst effect of the crash upon unemployment will have been passed during the next sixty days." – Washington Dispatch.

http://www.doublestandards.org/depression1.html

Quotations from the Great Depression

May 1, 1930 275

"While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover. There is one certainty of the future of a people of the resources, intelligence and character of the people of the United States – that is, prosperity." – President Hoover

June 29, 1930 219 "The worst is over without a doubt." – James J. Davis, Secretary of Labor.

August 29, 1930 238 "American labor may now look to the future with confidence." – James J. Davis, Secretary of Labor.

September 12, 1930 241 "We have hit bottom and are on the upswing." – James J. Davis, Secretary of Labor.

October 16, 1930 197 "Looking to the future I see in the further acceleration of science continuous jobs for our workers. Science will cure unemployment." – Charles M. Schwab.

October 20, 1930 193 "President Hoover today designated Robert W. Lamont, Secretary of Commerce, as chairman of the President's special committee on unemployment." – Washington dispatch.

October 21, 1930 186 "President Hoover has summoned Colonel Arthur Woods to help place 2,500,000 persons back to work this winter." – Washington Dispatch

November 1930 183 "I see no reason why 1931 should not be an extremely good year." – Alfred P. Sloan, Jr., General Motors Co.

January 20, 1931 166 "The country is not in good condition." – Calvin Coolidge.

June 9, 1931 133 "The depression has ended." – Dr. Julius Klein, Assistant Secretary of Commerce.

August 12, 1931 138 "Henry Ford has shut down his Detroit automobile factories almost completely. At least 75,000 men have been thrown out of work." – The Nation.

http://www.doublestandards.org/depression1.html

Quotations from the Great Depression

Hank Paulson, May 2008 to the Wall Street Journal:

"I do believe that the worst is likely to be behind us."

Probability Neglect

Table 1. Willingness to Pay in Dollars for Elimination of Arsenic Risks

Median Response

Unemotional Emotional Probability description description1/1,000,000 25 100 1/100,000 100 100

• Panic selling. • Pollyannish buying. • Making investment decisions, it is critical to distinguish between

1 chance in 10 and 1 in 100, though our brains are not wired to do so.

Opportunities in the UnknowableDavid Ricardo

Battle of WaterlooFour days before the battle. He understood “dismal forebodings.”

• Not a military analyst BAD• No basis to compute the odds BAD

BUT• Knew that the competition was thin. GOOD• The seller was eager. GOOD• The pounds if he won would be worth much more than the

pounds if he lost. VERY GOOD

The financing was 36 million pounds. Ricardo took a substantial share. Malthus bailed out on 5,000 pounds. Ricardo made more than $50 million by today’s standards, and that does not allow for the increased value of the pound.

Risk, Uncertainty and Ignorance Escalating Challenges to Effective Investing

Overall goal: Select assets that will do well when future states of the world become known.

Probabilities known: RISK. Merely an portfolio optimization problem. CAPM

Probabilities unknown: UNCERTAINTY. Big payoff to person who estimates probabilities the best. Warren Buffett’s approach.

Real world of investing ratchets the level of non-knowledge into still another dimension. Even the IDENTITY and NATURE of POSSIBLE FUTURE STATES are UNKNOWN.

The WORLD OF IGNORANCE. One can’t sensibly assign probabilities to the unknown states of the world.

Risk – Modern finance theory triumphs.

Uncertainty – Modern finance theory hits the wall.

Ignorance – Unknown and unknowable (UU) – Need new skills. Standard investors steer clear. Greatest profits available.

Table 1. Escalating Challenges to Effective InvestingTable 1. Escalating Challenges to Effective Investing

Knowledge of Knowledge of States of the WorldStates of the World

InvestmentInvestmentEnvironmentEnvironment

SkillsSkillsNeededNeeded

RiskRisk Probabilities knownProbabilities known Distributions of returns Distributions of returns knownknown

Portfolio optimization.Portfolio optimization.

UncertaintyUncertaintyUU

Probabilities unknownProbabilities unknown Distributions of returns Distributions of returns conjecturedconjectured

Portfolio optimization.Portfolio optimization.

Decision theory.Decision theory.

IgnoranceIgnoranceUUUU

States of the world States of the world unknownunknown

Distributions of returns Distributions of returns conjectured, often from conjectured, often from deductions about deductions about other’s behavior. other’s behavior.

Complementary skills often Complementary skills often rewarded along side rewarded along side investment.investment.

Portfolio optimization. Portfolio optimization.

Decision theory. Decision theory.

Complementary skills Complementary skills (ideal).(ideal).

Strategic inference.Strategic inference.

Opportunities in the Meltdown A. Prices out of line between stocks.

Brookfield Infrastructure Properties.Closed-end funds, conglomerates. Toyota Industries (Marty Whitman) – selling just over $20…$22 of Toyota Motors stock, $8-9 other portfolio companies, $2 in earningsGazprom, down 67% this year…Other international oils down modestly.

B. Tax strategies. Sell losers. Capitalize on highly volatile assets for tax losses.

C. Go to the source. If you really know the details on a stock you are much better off than usual.

D. Capitalize on the weakness of others.Buffett and the need for reassurance. Provision of capital for nearly completed deals.

Dreary and Positive Conclusions Dreary 1. Unknown and unknowable situations are widespread. (As

unknowable today as 1997 Asian meltdown, 9/11 attacks, NASDAQ soar and swoon at turn of century, subprime crisis, 2008 meltdown)

Aggregate versus idiosyncratic unknowables. Idiosyncratic: Will Vietnam let me sell my insurance product on a widespread basis? Will my friends’ new software product capture significant market share? LAND OF BIG PAYOFF.

Dreary 2. Most investors, even professionals, trained to deal with world where states and probabilities are known, have little idea of how to deal with the unknowable.

They recognize its presence, but they steer clear.

Positive 1. Unknowable situations have been and will be associated with remarkably powerful investment returns.

Will have losses, and will be blameworthy after the fact. But the net results will be strongly positive.

LEAVE THIS LECTURE IF BLAME AVERSION IS A PRIME CONCERN.

Three-Prong Test for Big Positive Expected Value Bets

1. UU underlying features.2. Complementary capabilities are required to undertake

them. (Hence limited competition.)3. Unlikely that party on the other side of the transaction is

better informed.

Unknowable

Complementary Capabilities

No Edge to Other Side

Not common, but not rare. Will not scale up like NYSE stock.Top-flight investors are always on the lookout. Warren Buffett trolls for them.

Complementary Skills

Few of us have capability to be: Real estate developer Venture capitalist High tech pioneer

Unusual judgment Buffett – But also gets investments that you and I

would not, savvy, reputation, discounted price Successful investors explain their success … others

can’t follow. Seem like nice guys.

Sidecar Investments

• Pulled along by a powerful motorcycleConfidence in driver’s integrity and motorcycle capabilities

• Price lower due to limited competition

• Premier sidecar investment Berkshire Hathaway

Buffett paid $100,000 with no options

Conclusions and Implications

• Mr. Market will always continue to change his behavior.• The most important probabilities will always be ambiguous.• The world is essentially unknowable, at least for big opportunities.• Money management is always a first priority.• Individual investments:

– Consider your knowledge relative to seller.– Seek sidecar investments.– With investing, as in any commercial activity, competition is the enemy.

• The greatest opportunities exist when unknowables abound.• When others sit, it is your time to act.