GUEST BLOG: Edge over the markets and do you have it?

Guest blog from author and former hedge fund manager Lars Kroijer.

This is a guest post from author and former hedge fund manager Lars Kroijer. The piece reflects his own opinion and is not endorsed by Reuters. The views expressed  do not constitute research, investment advice or trade recommendations.

Most literature or media on finance today tells us how to make money.  We are bombarded with stock tips about the next Apple or Google, read articles on how India or biotech investing are the next hot thing, or told how some star investment manager’s outstanding performance is set to continue.  The implicit message is that only the uninformed few fail to heed this advice and those that do end up poorer as a result.  We wouldn’t want that to be us!

What if we started with a very different premise?  The premise that markets are actually quite efficient.  Even if some people are able to outperform the markets, most people are not among them.  In financial jargon, most people do not have edge over the financial markets, which is to say that they can’t perform better than the financial market through active selection of investments different from that made by the market.  Embracing and understanding this absence of edge as an investor is something I believe is critical for all investors to understand.

Consider these two investments portfolios:

A) S&P500 Index Tracker Portfolio like an ETF or index fund

B) A portfolio consisting of a number of stocks from the S&P 500 – any number of stocks from that index that you think will outperform the index.  It could be one stock or 499 stocks, or anything in between, or even the 500 stocks weighted differently from the index (which is based on market value weighting).

If you can ensure the consistent outperformance of portfolio B over portfolio A, even after the higher fees and expenses associated with creating portfolio B, you have edge investing in the S&P 500.  If you can’t, you don’t have edge.

At first glance it may seem easy to have edge in the S&P500.  All you have to do is pick a subset of 500 stocks that will do better than the rest, and surely there are a number of predictable duds in there.  In fact, all you would have to do is to find one dud, omit that from the rest and you would already be ahead.  How hard can that be?  Similarly, all you would have to do is to pick one winner and you would also be ahead.

Although the examples in this piece are from the stock market, investors can have edge in virtually any kind of investment all over the world.  In fact there are so many different ways to have edge that it may seem like an admission of ignorance to some to renounce all of them.  Their gut instinct may tell them that not only do they want to have edge, but the idea of not even trying to gain it is a cheap surrender.  They want to take on the markets and outperform as a vindication that they “get it” or are somehow of a superior intellect or street-smart.  Whatever works!

The Competition

When considering your edge who is it exactly that you have edge over?  The other market participants obviously, but instead of a faceless mass, think about whom they actually are and what knowledge they have and analysis they undertake.

Imagine the portfolio manager – let’s call her Susan – of the technology-focused fund for a highly rated mutual fund/unit trust who like us is looking at Microsoft.

Susan and and her firm have easy access to all the research that is written about Microsoft including the 80 page in-depth reports from research analysts from all the major banks including places like Morgan Stanley or Goldman Sachs that have followed Microsoft and all its competitors since Bill Gates started the business.  The analysts know all of the business lines of Microsoft, down to the programmers who write the code to the marketing groups that come up with the great ads.  They may have worked at Microsoft or its competitors, and perhaps went to Harvard or Stanford with senior members of the management team.  On top of that, the analysts speak frequently with the trading groups of their banks who are among the market leaders in the trading of the Microsoft shares and can see market moves faster and more accurately than almost any trader.

All research analysts will talk to Susan regularly and at great length because of the commissions her firm’s trading generates.  Microsoft is a big position for her fund and Susan reads all the reports thoroughly – it’s important to know what the market thinks.  Susan enjoys the technical product development aspects of Microsoft and she feels she talks the same language as techies, partly because she knew some of them from when she studied computer science at MIT.  But Susan’s somewhat “nerdy” demeanour is balanced out by her “gut feel” colleague, who see bigger picture trends in the technology sector and specifically sees how Microsoft is perceived in the market and ability to respond to a changing business environment.

Susan and her colleagues frequently go to IT conferences and have meetings with senior people from Microsoft and peer companies, and are on first name basis with most of them.  Microsoft also arranged for her firm to visit the senior management at offices around the world, both in sales roles and developers, and Susan also talk to some of the leading clients.

Like the research analysts from the banks, Susan’s firm has an army of expert PhD’s who study sales trends and spot new potential challenges (they were among the first to spot Facebook and Google).  Further, her firm has economists who study the US and global financial system in detail as the world economy will impact the performance of Microsoft.  Her firm also has mathematicians with trading pattern recognition technology to help with the analysis.

Susan loves reading books about technology and every finance/investing book she can get her hands on, including all the Buffett and value investor books.

Susan and her team know everything there is to know about the stocks she follows (including a few things she probably shouldn’t know, but she keeps that close to her chest), some of which are much smaller and less well researched than Microsoft.  She has among the best ratings among fund managers in a couple of the comparison sites, but doesn’t pay too much attention to that.  After doing this for over twenty years she knows how quickly things can change and instead focuses on remaining at the top of her game.

Does Susan have edge?

Do you think you have edge over Susan and the thousands of people like her?  If you do, you might be brilliant, arrogant, the next Warren Buffett or George Soros, be lucky, or all of the above.  If you don’t, you don’t have edge.  Most people don’t.  Most people are better off admitting to themselves that once a company is listed on an exchange and has a market price, then we are better off assuming that this is a price that reflects the stock’s true value, incorporating a future positive return for the stock, but also a risk that things don’t go do plan.  So it’s not that all publicly listed companies are good – far from it – but rather that we don’t know better than to assume that their stock prices incorporate an expectation of a fair future return to the shareholders given the risks.  We don’t have edge.

When I ran my hedge fund I would always think about the fictitious Susan and her fund.  I would think of someone super clever, well connected, product savvy yet street-smart who had been around the block and seen the inside stories of success and failure.  And then I would convince myself that we should not be involved in trades unless we clearly thought we had edge over them.  It is hard to convince yourself that this is possible, and unfortunately even harder sometimes for it to actually be true.

Investing without edge

For someone to accept that they don’t have edge is a key “aha” moment in their investing lives, and perhaps without knowing it at first, they will be much better off as a result.  At this point you are hopefully at least considering a couple of things:

1. Edge is hard to achieve and it is important to be realistic about if you have it.

2. Conceding edge is a sensible and very liberating conclusion for most investors.  It makes life lot easier (and wealthier) to acknowledge that you can’t better the aggregate knowledge of a market swamped with thousands of experts that study Microsoft and the wider markets.

Once you have conceded edge you are unfortunately not done.  In fact you have only arrived at the starting point and started your journey as an investor who has conceded edge.  There is every change that you will be a far wealthier investor as a result of this.

For the edgeless investor it makes sense to pick the most diversified and cheapest portfolio of world equities and combining that with some government and potentially corporate bonds through cheap index tracking products that suit your risk and tax profile.  Do this while considering your non-investment assets/liabilities, time horizon of investment, and a few other things, and you are doing extremely well.  Once you embrace that you don’t have edge it is fortunately pretty intuitive and really not that difficult to put together a simple and powerful investment portfolio.  More on that in the next blog!


Lars Kroijer is the author of “Investing Demystified – How to Invest Without Speculation and Sleepless Nights” from Financial Times Publishing. He founded hedge fund Holte Capital, where he was CEO, in 2002. You can follow him on @larskroijer.

Jim Chanos, bad news bear, urges market prudence

Prominent short-seller Jim Chanos is probably one of the last true “bad news bears” you will find on Wall Street these days, save for Jim Grant and Nouriel Roubini. Almost everywhere you turn, money managers still are bullish on U.S. equities going into 2014 even after the Standard & Poor’s 500’s 27 percent returns year-to-date and the Nasdaq is back to levels not seen since the height of the dot-com bubble in 1999.

Prominent short-seller Jim Chanos is probably one of the last true “bad news bears” you will find on Wall Street these days, save for Jim Grant and Nouriel Roubini. Almost everywhere you turn, money managers still are bullish on U.S. equities going into 2014 even after the Standard & Poor’s 500’s 27 percent returns year-to-date and the Nasdaq is back to levels not seen since the height of the dot-com bubble in 1999.

“We’re back to a glass half-full environment as opposed to a glass half-empty environment,” Chanos told Reuters during a wide ranging hour-long discussion two weeks ago. “If you’re the typical investor, it’s probably time to be a little bit more cautious.”

Chanos, president and founder of Kynikos Associates, admittedly knows it has been a humbling year for his cohort, with some short only funds even closing up shop.

But he told Reuters that the market is primed for short-sellers like him and as a result has gone out to raise capital for his mission: “Markets mean-revert and performance mean-reverts and even alpha mean-reverts if at least my last 30 years are any indication. And the time to be doing this is when you feel like the village idiot and not an evil genius, to paraphrase my critics.”

Chanos’ bearish views are so well respected that the New York Federal Reserve has even included him as one of the money managers on its investment advisory counsel. By his own admission, Chanos said he tends to be the one most skeptical on the markets.

Chanos knows bad news when he sees it as he is known as the man who almost single handedly vindicated short sellers by revealing the ongoing fraud at Enron and WorldCom. And he sounded the alarm bell early on struggling computer giant Hewlett Packard. Just last week, he sent shares of CGI Group Inc., the parent of CGI Federal, which is the main contractor behind the U.S. government’s glitch-plagued website, under selling pressure after Newsweek revealed that Chanos had placed a major short position.

Chanos spoke about his other shorts including Caterpillar and – yes, just in time for Christmas — coal stocks at the Reuters Global Investment Outlook Summit and even shared some of his observations on the 1 percent and what they owe the rest of us.

On the U.S. stock market

Chanos: “A few years back, I felt the U.S. was the best house in a bad neighborhood for a cliché hackneyed term and certainly there were better places that I think on a macro basis to be short like China. Our thinking is changed on that now. I think that the U.S. market is pretty fully discounting an awful lot of good news. While one can never be precise on markets and that’s not why my clients pay me, we’re finding many more opportunities (on the short side) in the U.S markets than we found a few years ago. The U.S. market at roughly 1,800 on the S&P is trading at 19 times earnings. I am always sort of befuddled because people use a much lower figure on that…we went back and triple-checked trailing 12-month S&P 500 earnings and they are only $95. A lot of companies report earnings before the bad stuff and we’re talking about GAAP earnings – actually talking about real accounting earnings – they are only $95. So for you to believe that the market is only at 14 times, 15 times next year’s number, you have to make some pretty robust assumptions on earnings growth to get to $95 to that $120 or $125 figure.”

Déjà vu all over again

Chanos: “I recall pretty vividly in 2007 at the top people were saying that ‘Well, the markets weren’t that expensive.’ And yet, we had a little bit of a dislocation following that. Of course, everybody will say, ‘Yeah but the markets could go to whatever…because it did in 2000.’ If you want to use as your benchmark, a once-in-a-lifetime, mainly the Nasdaq as your guidepost what is cheap or not, Good luck. We’re at the same kinds of levels we’ve been at in ’07 and in other periods where the markets had some difficulty. Having said that, the Fed is going to stay easy for a long time, so they tell you, so people are taking that as a given. But there are other some other signposts that are a lot different from four years ago.

Back then, you saw very little (stock) issuance, now issuance is picking up very, very quickly. We see three-four-five spot secondaries every night beyond the IPO market. You’re seeing hedge funds scrap the short side – and in some cases, bring out long-only funds. That was a hallmark of 2007 as well. In 2009, everybody wanted tail risk protection. I haven’t heard about tail risk protection in probably 18 months. We’re back to a glass half-full environment as opposed to a glass half-empty environment. If you’re the typical investor, it’s probably time to be a little bit more cautious. It doesn’t mean the market can’t go a lot higher. And as I say, we’re pretty much in our short-only business always defacto hedged but the risks are getting out there. And even in some stocks we’re you’re beginning to see research reports now stretched out and tell you the stock is reasonably priced based on 2020 estimates, most people can’t really forecast much beyond a few months — and we’re seeing more and more of those kinds of reports where stocks are justified based on some enormous growth way, way out into the future. And to some extent Fed policy fosters that because of the low interest rates people feel that they can be confident in predicting out reasonably high multiples with no hiccups going out in the future.”

You love art, so what do you make of the surge in Sotheby’s shares?

Chanos: “At Sotheby’s basically it goes from 10 to 50 seemingly in every cycle since the late 80s. There are some reasons for that — contemporary art is what I call ‘socially acceptable conspicuous consumption.’ So in any case, but it’s sort of an interesting point that every time we seem to see some sort of excess somewhere in the marketplace, Sotheby’s runs to 50 and then collapses to 10 and then runs right back to 50 and collapses to 10. It’s done that four times since the late 80s. And now we’ve seen the latest ramp to 50. And who knows.

Again, it’s more to me an indicator of what the 1% is doing than anything else.”

Are we in a hedge fund bubble?

Chanos:  “I think hedge fund fees are probably still in a bubble although I would point out that the reality is that the days of 2-20 are kind of well behind us and even a lot of shops that charge that effectively make a lot less.

Also, the investors have gotten a lot more sophisticated. Ten years ago, if you were dealing with a pension fund you really dealt with a consultant, by and large. And they were the gate keepers and if they liked you, then you get put on a list. Nowadays you really deal directly with the clients. They all have staff that are pretty sophisticated.”

Are you raising money now for your funds?

Chanos: “We think now is a good time to do it. Now I think is not a bad time to be raising capital for what we do. When we got a rough going in the mid-90s, that was exactly the time to raise capital. It is counterintuitive and a lot of hedge funds don’t do it. But markets mean-revert and performance mean-reverts and even alpha mean-reverts in at least my last 30 years are any indication and the time to be doing this is when you feel like the village idiot and not an evil genius, to paraphrase my critics. And I think that’s the time as I say when everybody wanted tail risk insurance back in ‘09, we were pushing our hedge fund more than our short fund. And now I think the short fund actually makes more sense for institutional investors.

At this point I think it is prudent for people to think about hedging off some of their market exposure and that is exactly when they don’t wanna do it.”

On Caterpillar

Chanos: “One of our views is that we think the commodity super cycle has peaked. But the problem in saying that is that most analysts and investors have a very short time frame in looking at that. We took a look at the publicly-traded mining companies with one of our brokers and we went back and looked at all of their capital spending going back to the early 90s in the mining area and capital spending in the mining area is roughly 50% equipment and 50% the cost of digging the hole. And it’s pretty amazing what you see, that from 1991-2001, basically capital spending in the entire mining industry went from $5 billion a year to $15 billion a year. That’s about an 8-9% compounded growth rate. And then, the China boom came and then from ’01 to 2012, annual capital spending in the mining industry went from $15 billion a year to $145 billion a year! Which is a 24% compounded rate of return. It went from an arithmetic function to a geometric function in the post-millennium and it’s come off a little bit from that peak now. When you understand just what a massive boom we have had in digging holes in the ground globally to fill this voracious demand in China in building these cities and people say, ‘Oh, well, Caterpillar in the down cycle earned 4-5-6 bucks. Caterpillar used to lose money in the down cycles and that’s when it was basically only a duopoly in 80s and early 90s. Now, you have five, six or seven players in that market and all basically working on the assumption that the hockey stick chart is sort of the new normal and if we ever revert to the mean because China stops building one new city seemingly every every weekend, I think that a lot of equipment guys got has a lot of extra capacity and returns are going to be a lot lower than investors think. That’s the basic thesis.”

On Coal

Chanos: “We’re very bearish on coal for a variety of reasons. I think it’s the flipside of the shale gas boom in the U.S. But you’re even beginning to see some movement shockingly in China to cut back on burning coal because, let’s face it, the pollution issue there…I think that it’s still cheaper in the European markets and Asian markets to burn coal than natural gas but that’s because natural gas is $10-12 and $14-16 in Asia. There’s more and more coal being mined similar to this boom, so the supply keeps coming. In the U.S., there’s additional issues and that is, the EPA is on the case here pretty diligently — on top of the real substitution effect that natural gas has. We’re pretty much short all the leveraged coal companies with one exception, which is one of our hedges. But you can assume pretty much that we are short all of the leveraged coal companies. If you look at the numbers in the coal companies, these are companies, really, some of them in financial distress or about to be.”

Bill Gross, manager of the world’s largest bond fund, urged fellow members of the “privileged 1 percent,” earning the highest incomes, to support higher U.S. taxes on carried interest and capital gains to help the economy. (Carried interest refers to a large portion of the investment gains realized by private equity managers and executives at some venture capital firms, real estate and hedge funds.)

Your thoughts on carried interest & the 1 percent

Chanos: “I think it will ultimately go away. At some point, it’s going to be raised. I don’t know when. I’m shocked it’s lasted this long. But at the end of the day, it seems to me that the concept of – and make no mistake about it, we’ve been very public on this – that carried interest is fee income — no ifs, ands or buts about it. It is fee income. If I run money in a partnership, and I run money in a managed account, and I run the pari passu which I do, and one of them reallocates the profit partnership at the end of the year based on performance, the other actually pays me a fee based on the same exact performance, you’re telling me that one is capital gains and the other is income? It’s ridiculous. The fact that this loophole has stayed open for this long tells you a lot about the process in Washington and it does about economics.”