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Ten Lessons (Not?) Learnt

Asset AllocationJames Montier

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Lesson I: Markets aren’t efficient

A long litany of bad ideas:CAPMAlpha and BetaBlack and ScholesRisk management Mark-to marketM&M dividend and capital structure irrelevanceShareholder ValueRegulatory regime

Most insidious aspects of EMH are the advice on sources of outperformanceInside information (illegal in most places)If you can see the future better than everyone elseAlso tells us that opportunities will be fleeting

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Not a drop of evidence that we can forecast anything at all

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Economist forecast

Actual result

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Forecast error over time: US and European markets 2001-2006, %

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Analyst expected returns (via target prices) and actual returns (US, %)

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Analysts’ forecastActual outturn

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Analysts’ forecastActual outturn

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Lesson II: Relative Performance is a dangerous game

Homo Ovinus

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Institutional investors vs. US market (weight difference)

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Source: Lewellen (2009)

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Many active managers aren’t even trying!

Lewellen concludes:“Quite simply, institutions overall seem to do little more than hold the market portfolio. Their aggregate portfolio almost perfectly mimics the value-weighted index... Institutions overall take essentially no bet on any of the most important stock characteristics known to predict returns, like B/M, momentum, or accruals. The implication is that, to the extent that institutions’ holdings deviate from the market portfolio, they seem to bet primarily on idiosyncratic returns – bets that aren’t particularly successful. Another implication is that institutions, in aggregate, don’t exploit anomalies in the way they should.”

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Why not? Career and Business risk (Homo Ovinus rides again)

Cohen et al ‘Best Ideas’

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B e s t Id e a s M a r k e t

Cohen et al conclude“The poor overall performance of

mutual fund managers… is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to overdiversify.”

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Performance around hiring and firing decisions (%)

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Lesson III: This time is never different

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1 12 23 34 45 56 67 78 89 100 111 122Months

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Mill/Minsky/Kindleberger framework for bubbles

Displacement

Credit Creation

Euphoria

Critical Stage/Financial Distress

Revulsion

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Why don’t we see bubbles?

Black Swans– Unpredictable– Massive Impact– Ex-post rationalization

Predictable Surprise– At least some where aware of the

problem– The problem gets worse over time– Eventually explodes into crisis

Five impediments to recognising predictable surprises:(i) Over-optimism(ii) The illusion of control(iii) Self-serving bias(iv) Myopia(v) Inattentional blindness

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Lesson IV: Valuation Matters (in the long run)

Source: GMO

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Buy when it’s cheap: if not then, when?

Buying at 10x G&D PE

124-19Average64-11982.0331-41942.03

218-531931.10183-161917.09

Months before mkt return to purchase levelMonths to market trough% decline from purchase to market troughDate of Purchase

US market 1881-2008

1001001001001008524212510213187243126112134510010010010083818515-168293524134995100909282-383-72-11-249380433726109294919280-38-11-18-26-241016741342113

10 Yr5 Yr3 Yr2 Yr1 Yr10 Yr5 Yr3 Yr2 Yr1 Yr10 Yr5 Yr3 Yr2 Yr1 Yr

% of times subsequent return positiveWorst Subsequent ReturnSubsequent Average Return

Source: GMO

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Graham and Dodd PE (S&P500)

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Source: GMO

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Bottom up valuation: What would Ben think?

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UK Europe US Japan Asia

Now Mar-09 Nov-08

% of stocks passing BG conditions

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Lesson V: Wait for the “fat pitch”

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1 2 3 4 5 6 7 8 9 10 11 12Source: Plottt et al

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ADHD and stock holding periods

Source: NYSE

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1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

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Lesson VI: Sentiment matters

Source: GMO

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Low PE High PE

Low SentimentHigh Sentiment

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Exploiting sentiment (US 1962-2000)

Source: Baker and Wurgler

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Age (old vs young) Volatility (high vs low) Profitability (high vs low)

Sentiment LowSentiment High

When sentiment is low: Buy young, volatile, unprofitable firmsWhen sentiment is high: Buy old, stable, profitable firms

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Sentiment suggests need for caution

96 97 98 99 00 01 02 03 04 05 06 07 08 0915

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ADVISORS SENTIMENT BEARISH Source: DATASTREAM

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Lesson VII: Leverage can’t turn a bad investment good

• Leverage can’t turn a bad investment good, but it can turn a good one bad

• Limits staying power

• Can turn a temporary impairment (i.e. price volatility) into a permanent impairment of capital

• Beware of financial innovation…often just leverage in a thinly veiled disguise

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Lesson VIII: Beware of over-quantification

Ben Graham: “Mathematics is ordinarily considered as producing precise and dependable results; but in the

stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw there from…Whenever calculus is brought in, or higher algebra, you could take it as a warning that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.”

Keynes:“With a free hand to choose coefficients and time lag, one can, with enough industry, always

cook a formula to fit moderately well a limited range of past facts.I think it all hocus - but everyone else is greatly impressed, it seems, by such a mess of

unintelligible figures.”

Munger: “It seems like higher mathematics with false precision should help you, but it doesn’t. They teach

that in business schools because, well, they’ve got to do something!”

There are no points for elegance in the real world.

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Risk isn’t a number

Risk isn’t volatility, it is the permanent impairment of capital

Volatility creates the opportunity.

Keynes again:“It is largely fluctuations which throw up the bargains and the uncertainty due to

fluctuations which prevents other people from taking advantage of them.”

Think about risk as a trinity:Valuation riskBusiness riskFinancing risk

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Lesson IX: There is no substitute for skepticism

Santayana: “Skepticism is the chastity of the intellect, and it is shameful to surrender it too soon or

to the first comer: there is nobility in preserving it coolly and proudly.”

We are in the rejection game.

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Lesson X: Benefits of cheap insurance

Insurance is often disliked in investing, because of the nature of the cash flows, but that often makes it cheap!

Examples:Inflation insuranceMoral hazard/market melt up insurance

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Long-term volatility

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28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09

Source: SG, Bloomberg

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Lessons (not) learnt

I. Markets aren’t efficientII. Relative performance is a fool’s gameIII. This time is never differentIV. Valuation mattersV. Wait for the fat pitchVI. Sentiment mattersVII. Leverage can’t make a bad investment goodVIII. Beware of over-quantificationIX. There is no substitute for skepticismX. Don’t underestimate the use of cheap insurance

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