Review – The Outsiders

The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success

by William N. Thorndike, Jr., published 2012

Capital allocation uber alles

“The Outsiders” rests on a premise, that the increase in a public company’s per share value is the best metric for measuring the success of a given CEO, which lends itself to the book’s major thesis: that superior capital allocation is what sets apart the best CEOs from the rest, and that most modern CEOs seem to be only partially aware, if at all, of its critical performance to their companies long-term business success.

Notice! This book is examining the efforts and measurements of CEOs of public companies, not all businesses (public and private), so as a result in comes up a bit short in the “universal application” department. Yes, capital allocation is still critical even in a private business, but you can not measure a private business’s per share value (because there isn’t a marketable security price to reference) and the CEO of a private company is missing one of the most powerful capital allocation tools available to public CEOs, the share buyback (because there is no free float for them to get their hands on at periodically irrational prices).

The CEO capital allocation toolkit

Thorndike describes five capital allocation choices CEOs have:

  1. invest in existing operations
  2. acquire other businesses
  3. issue dividends
  4. pay down debt
  5. repurchase stock

Along with this, they have three means of generating capital:

  1. internal/operational cash flow
  2. debt issuance
  3. equity issuance

With this framework, Thorndike proceeds to review the business decisions of 8 different “outsider” CEOs, so labeled because they tended to use these tools in a contrary fashion to the mainstream wisdom of their time and to much improved effect as per comparison to their benchmarks. Some of the CEOs are well known and oft mentioned and studied (Warren Buffett, John Malone, Kay Graham, Tom Murphy) and a few are known to the value cognoscenti but may have managed to escape notice of the wider public, academic or otherwise (Henry Singleton, Bill Anders, Bill Stirlitz and Dick Smith).

The author tries to tie together the various common threads, such as how,

All were first-time CEOs, most with very little prior management experience

and many of which (such as Singleton, Buffett and Graham) were large or majority equity holders in their companies, making them part of the vaunted owner-operator club with its resulting beneficial incentives.

Thorndike also tries to use the hedgehog vs. fox metaphor, claiming,

They had familiarity with other companies and industries and disciplines, and this ranginess translated into new perspectives, which in turn helped them to develop new approaches that eventually translated into exceptional results

Interestingly, the share buyback stands out as a particularly effective capital allocation tool for all and the author claims that during the difficult inflationary conditions and market depression of the 1974-1982 period,

every single one [emphasis in the original] was engaged in either a significant share repurchase program or a series of large acquisitions

In broad strokes, Thorndike’s efforts to paint these CEOs with a common brush works, but there are numerous times where his attempt to establish commonality  in genius comes across as forced and unworkable. Often, one of these CEOs will operate in a way inconsistent with Thorndike’s major thesis and yet he’ll end up praising the CEO anyway. In poker, we’d call this the “won, didn’t it?” fallacy– judging a process by the specific, short-term result accomplished rather than examining the long-term result of multiple iterations of the process over time.

Some quibbles

This is actually one of the things that rubbed me rather raw as I read the book. In every chapter, Thorndike manages to strike a rather breathless, hagiographic tone where these CEOs can do no wrong and everything they do is “great”, “fantastic,” etc. Unfortunately, this kind of hyperbolic language gets used over and over without any variety to the point it’s quite noticeable how lacking in detail and critical analysis Thorndike’s approach is at points.

Eventually, I reached a point where I almost wanted to set the book down, take a deep breath and say, “Okay… I get it, this guy is absolutely amazing… can we move on now?”

The editing seemed a bit sloppy, too. Thorndike is a graduate of Stanford and Harvard and runs his own financial advisory. He’s obviously an accomplished, intellectual person. Yet his prose often reads like an immature blog post. It’s too familiar and casual for the subject matter and the credentials of the author. I’m surprised they left those parts in during the editing process. I think it makes Thorndike’s thesis harder to take seriously when, in all likelihood, it’d probably be quite convincing if you happened to chat with the author on an airplane.

From vice to virtue

Something I liked about “The Outsiders” was the fact that there were 8 profiles, rather than one. It was reinforcing to see that the same principles and attitudes toward business and management were carried out by many different individuals who didn’t all know each other (though some did) and ALL had huge outperformance compared to their benchmark.

And I think for someone who is just jumping into the investing, management and agency problem literature, “The Outsiders” is a good place to start to get a broad outline of the major thesis which is that companies that are run by owner-operators, or by people who think like them, where the top management focuses on intelligently allocating capital to its highest use (which, oftentimes when the company’s stock remains stubbornly low compared to its estimated intrinsic value, makes buybacks in the public market the most intelligent option versus low margin growth) consistently outperform their peers and their benchmarks on a financial basis.

I think if this was one of the first books I had read on this theme, I would’ve found it quite illuminating and exciting, a real eye-opener experience. As it were, I read this book after reading a long train of other, often times significantly more comprehensive and detailed literature, so my personal experience was rather flat– I came away thinking I hadn’t learned much.

More to the story

There’s more to this story in two senses.

In the first sense, I actually highlighted many little comments or ideas throughout the book that are either helpful reminders or concepts I hadn’t fully considered myself yet, pertaining to best operational and management practices for businesses and the people who invest in them. In other words, the book is a little deeper than I bothered to share here. As a collection of anecdotes and principles for mastering the concept of capital allocation, it’s a good resource.

In the second sense, I think there’s a lot more to the success of the businessmen and their companies profiled (along with many others) than just good capital allocation. The text alludes to this with quotes from various figures about how they operated their businesses and managed people aside from the specific challenges of capital allocation. But it never goes into it because that isn’t in focus.

And as a business person myself, I know from my own reading, thinking and personal experience that capital allocation IS a critical factor in successfully managing and growing a business over the long-term — after all, if you can’t find good places to put your cash, you’ll inevitably end up wasting a lot of it — but you won’t have capital to allocate if you aren’t operating your business and managing your relationships with employees and customers well, in addition. The book just doesn’t do much in the way of explaining how it was that Ralston Purina, or General Dynamics or Teledyne or what have you, had so much capital to allocate in the first place.

I think people like this book so much because it’s exciting to read about outsize success, regardless of how it happened.

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Doing The Hugh Hendry

Below is some commentary from Hugh Hendry I found in an FT.com editorial I since can not access as I don’t have a login. But I thought it was interesting when I first read it awhile back and I still think it’s interesting now. I meant to post it earlier. Rectifying my mistake:

For the moment, let us forget the chances of a hard landing in China. Forget the drama of Europe’s circus of politically inspired economic incompetency. Forget that the good news of the US economy’s succession of positive economic surprises is really bad news as fixed income managers have sold copious amounts of too cheap volatility and because it has made equity investors turn bullish, sending stock market volatility back to 2007 levels. This is dangerous. Improved US data may represent a classic short-term cyclical upturn amid a profound global deleveraging cycle.

Such moves have been commonplace for the past three years and have yet to prove a harbinger of any structural upswing. I worry that the pathological course of the last several years will see volatility rise sharply once again. Even so, there exists, in terms of my parochial world of hedge fund investing, a bigger issue.

I fear that my no longer small community has been compromised. Last year was generally very tough for long/short strategies and I commiserate with all concerned. But last year world class funds lost more than 15 per cent in just two months. Today they are celebrated again for making double digit returns in the last quarter even though they still languish below high water marks and their reputation for risk management, at least to those clients who have poured over their copious due diligence statements, has been sorely compromised.

You can probably live with that if you are a pension scheme or a large, sophisticated fund-of-fund because you have a global macro sub-sector that can benefit from short-term shifts in volatility. But the unfortunate thing is that this group exercised its stop losses somewhere between the great stock market rallies of 2009 and 2010. That is to say, they honoured the pact they had with clients. They adhered to the terms of their risk budget: they lost money and they reduced their positions. I fear that owing to this nasty experience the financial world is in danger of harvesting a monoculture of fund returns that could prove less than robust should the global economy suffer another deflationary reversal.

To my mind the situation has parallels with the plight of the banana. Today the world eats predominately just one type of banana, the Cavendish, but it is being wiped out by a blight known as Tropical Race 4, which encourages the plant to kill itself. Scientists refer to it as programmed death cell destruction. In stressful situations bananas fortify themselves by dropping leaves, killing off weaker cells so that stronger ones may live to fight anew. They operate a stop-loss system.

But modern mass production of single type bananas has replaced jungle diversity with commercial monocultural fields that provide more hosts to harbour the blight. The economy keeps producing stressful volatility events. Good managers keep shedding risk and monetising losses and are duly fired, leaving us with a monoculture of brazen managers who will never stop loss because they are convinced central banks will print more money.

Diversification has proven the most robust survival mechanism against failures of judgment by any one society, hedge fund manager or style. But what if we are now a single global hedge fund community afraid to take stop losses and convinced of an inflationary outcome to be all short US Treasuries and long real assets?

This is pertinent as I have always been fascinated by that second rout in US Treasuries in 1984, long after the inflation of the 1970s was met head on by Paul Volcker’s monetary vice and a deep recession. How could 10-year Treasury yields have soared back to 14 per cent and how could so many investment veterans have been convinced that a second even more virulent inflation wave was to hit the global economy?

Psychologists tell us the explanation is embedded deep in the mind. They refer to the “availability heuristic”. Goaded by the proximity to the last dramatic event, investors overreacted to the news that the US economy was pulling out of recession in 1984. They saw high inflation where there was none.

With this in mind, I would contend that it may take several more years before the threat of debt and deflation can be successfully exorcised from investors’ minds, even if the global economy were not set on such a perilous course. Such is the potency and memory of 2008’s crash that anything remotely challenging to the economic consensus could be met by a sudden and severe reappraisal to the downside.

Should such an event send 30-year Treasury yields back to their 2008 low of 2.5 per cent, we believe enlightened investors might better be served by thinking the opposite. Only then might it prove rewarding to short the government bond market and embrace what may turn out to be a much promised once in a lifetime buying opportunity for risk assets.

 

Progress Requires Innovation, Innovation Requires Freedom; No Freedom, No Progress, That’s Government

Joe Quirk on seasteading:

Benjamin Franklin participated in several major innovations in his day. He helped discover and control electricity, and he helped design the US Constitution. The control of electricity set off a cascade of innovations, driving almost every modern technology we can name. Yet the instrument of government he helped invent has not progressed.

Consider that Franklin’s many inventions have advanced beyond his wildest imagination: the Franklin stove, bifocal glasses, refrigeration, the flexible urinary catheter (my favorite). Yet, the methods of government he helped invent have not evolved. And why?

Because inventors and entrepreneurs had the freedom to experiment with Franklin’s technological ideas, but not his political ideas. More importantly, as Patri [Friedman] says, customers had power to choose amongst gadgets competing to please them, while citizens are captive to the political system they inherit.

One day, people will laugh at the idea of government (legitimized, institutional theft and murder) just as today people laugh at the idea of monarchy as a system of government.

Government is a technology– it is a means for achieving particular ends. What people don’t understand right now is that

  1. government is a means, not an end and
  2. government is an inappropriate and contradictory means for the end of “living in a harmonious, civilized and prosperous human society”

Government reduces human relationships to the Laws of the Jungle, the very thing we all claim to be striving so mightily to avoid.

As Allen Thornton wrote in the early 1980s,

And just what is this government? It’s a man-made invention. It’s not some natural phenomenon or a special creation of God. Government’s an invention, just like the light bulb or the radio.

The state was invented for me, to make me happier, but a funny thing has happened: If I don’t want this invention, people are outraged. No one calls me unpatriotic for refusing to buy a light bulb. If I don’t choose to spend my money on a radio, no one says that I’m immoral. Why should anarchy upset everyone?

Anarchists are ahead of their time, even though the truth they speak is itself timeless– conservatively, probably 200-300 years ahead of their time. The gradual evolution of the “human collective social consciousness” over time has been away from absolutism and toward individualism, with various depressing but ultimately temporary and regional setbacks along the way. Most visionaries DO look like kooks to their neighbors and countrymen before their vision is realized.

But it is the “market purists” who will have the last laugh, and ultimately deliver every one into the closest thing to a perfect society that one can get while still remaining firmly in the grips of reality in this universe.

They’ll be naysayed and boohooed and shouted at quite a bit along the way, though. Good thing most of us are of stout heart and strong mind.

Review – More Money Than God

More Money Than God: Hedge Funds And The Making Of A New Elite

by Sebastian Mallaby, published 2010

A veritable pantheon of masters of the universe

Mallaby’s book is not just an attempt at explaining and defending the beginning, rise and modern state of the hedge fund industry (the US-focused part of it, anyway), but is also a compendium of all of the hedge fund world’s “Greatest Hits.” If you’re looking for information on what hedge funds are, where they come from, what they attempt to do, why they’re called what they are and how they should be regulated (SURPRISE! Mallaby initially revels in the success “unregulated” funds have had and feints as if he’s going to suggest they not be regulated but, it being a CFR book and he being a captured sycophant, he does an about-face right at the last second and ends up suggesting, well, umm, maybe SOME of the hedge funds SHOULD be regulated, after all) this is a decent place to start.

And if you want to gag and gog and salivate and hard-to-fathom paydays and multiple standard deviations away from norm profits, there are many here.

But that wasn’t my real interest in reading the book. I read it because I wanted to get some summary profiles of some of the most well known hedgies of our time — the Soroses and Tudor Joneses and such — and understand what their basic strategies were, where their capital came from, how it grew and ultimately, how they ended up. Not, “What’s a hedge fund?” but “What is this hedge fund?” As a result, the rest of this review will be a collection of profile notes on all the BSDs covered by the book.

Alfred Winslow Jones – “Big Daddy”

  • started out as a political leftist in Europe, may have been involved in U.S. intelligence operations
  • 1949, launches first hedge fund with $60,000 from four friends and $40,000 from his own savings
  • By 1968, cumulative returns were 5,000%, rivaling Warren Buffett
  • Jones, like predecessors, was levered and his strategy was obsessed with balancing volatilities, alpha (stock-picking returns) and beta (passive market exposure)
  • Jones pioneered the 20% performance fee, an idea he derived from Phoenician merchants who kept one fifth of the profits of successful voyages; no mgmt fee
  • Jones attempted market timing as a strategy, losing money in 1953, 1956 and 1957 on bad market calls; similarly, he never turned a profit following charts even though his fund’s strategy was premised on chartism
  • Jones true break through was harvesting ideas through a network of stock brokers and other researchers, paying for successful ideas and thereby incentivizing those who had an edge to bring him their best investments
  • Jones had information asymetry in an era when the investment course at Harvard was called “Darkness at Noon” (lights were off and everyone slept through the class) and investors waited for filings to arrive in the mail rather than walk down the street to the exchange and get them when they were fresh

Michael Steinhardt – “The Block Trader”

  • Background: between end of 1968 and September 30, 1970, the 28 largest hedge funds lost 2/3 of their capital; January 1970, approx. 150 hedge funds, down from 200-500 one year earlier; crash of 1973-74 wiped out most of the remainders
  • Steinhardt, a former broker, launches his fund in 1967, gained 12% and 28% net of fees in 1973, 74
  • One of Steinhardt’s traders, Cilluffo, who possessed a superstitious eating habit (refused to change what he ate for lunch when the firm was making money), came up with the idea of tracking monetary data, giving them an informational edge in an era where most of those in the trade had grown up with inflation never being higher than 2% which meant they ignored monetary statistics
  • One of Steinhardt’s other edges was providing liquidity to distressed institutional sellers; until the 1960s, stock market was dominated by individual investors but the 1960s saw the rise of institutional money managers; Steinhardt could make a quick decision on a large trade to assist an institution in a pinch, and then turn around and resell their position at a premium
  • Steinhardt’s block trading benefited from “network effects” as the more liquidity he provided, the more he came to be trusted as a reliable liquidity provider, creating a barrier to entry for his strategy
  • Steinhardt also received material non-public information: “I was being told things that other accounts were not being told.”
  • In December 1993, Steinhardt made $100M in one day, “I can’t believe I’m making this much money and I’m sitting on the beach” to which his lieutenants replied “Michael, this is how things are meant to be” (delusional)
  • As the Fed lowered rates in the early 90s, Steinhardt became a “shadowbank”, borrowing short and lending long like a bank
  • Steinhardt’s fund charged 1% mgmt fee and 20% performance fee
  • Anecdote: in the bloodbath of Japan and Canada currency markets in the early 90s, the Canadian CB’s traders called Steinhardt to check on his trading (why do private traders have communications with public institutions like CBs?)

Paul Samuelson & Commodities Corporation – “Fiendish Hypocrite Jackass” (my label)

  • Paul Samuelson is one of history’s great hypocrites, in 1974 he wrote, “Most portfolio decision makers should go out of business– take up plumbing, teach Greek, or help produce the annual GNP by serving corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed.”
  • Meanwhile, in 1970 he had become the founding backer of Commodities Corporation and also investing in Warren Buffett; he funded his investment in part with money from his Nobel Prize awarded in the same year
  • Samuelson paid $125,000 for his stake; total start-up capital was $2.5M
  • Management of fund resembled AW Jones– each trader was treated as an independent profit center and was allocated capital based on previous performance
  • Part of their strategy was built on investor psychology: “People form opinions at their own pace and in their own way”; complete rejection of EMH, of which Samuelson was publicly an adherent
  • Capital eventually swelled to $30M through a strategy of primarily trend-surfing on different commodity prices; in 1980 profits were $42M so that even net of $13M in trader bonuses the firm outearned 58 of the Fortune 500
  • Trader Bruce Kovner on informational asymetries from chart reading: “If a market is behaving normally, ticking up and down within a narrow band, a sudden breakout in the absence of any discernible reason is an opportunity to jump: it means that some insider somewhere knows information that the market has yet to understand, and if you follow that insider you will get in there before the information becomes public”

George Soros – “The Alchemist”

  • Soros had an investment theory called “reflexivity”: that a trend could feedback into itself and magnify until it became unavoidable, usually ending in a crash of some sort
  • Soros launched his fund in 1973, his motto was “Invest first, investigate later”
  • Soros quotes: “I stood back and looked at myself with awe: I saw a perfectly honed machine”; “I fancied myself as some kind of god or an economic reformer like Keynes”
  • Soros was superstitious, he often suffered from back pains and would “defer to these physical signs and sell out his positions”
  • Soros believed in generalism: know a little about a lot of things so you could spot places where big waves were coming
  • Soros had a “a web of political contacts in Washington, Tokyo and Europe”
  • Soros hired the technical trader Stan Druckenmiller, who sometimes read charts and “sensed a panic rising in his gut”
  • As Soros’s fund increased in size he found it harder and harder to jump in and out of positions without moving the markets against himself
  • Soros rejected EMH, which had not coincidentally developed in the 1950s and 1960s in “the most stable enclaves within the most stable country in the most stable era in memory”
  • Soros was deeply connected to CB policy makers– he had a one on one with Bundesbank president Schlesinger in 1992 following a speech he gave in Basel which informed Quantum fund’s Deutschemark trade
  • “Soros was known as the only private citizen to have his own foreign policy”; Soros once off-handedly offered Druckenmiller a conversation with Kissinger who, he claimed, “does know things”
  • Soros hired Arminio Fraga, former deputy governor of Brazil’s central bank, to run one of his funds; Fraga milked connections to other CB officials around the world to find trade ideas, including the number two official at the IMF, Stanley Fischer, and a high-ranking official at the central bank of Hong Kong
  • Soros was a regular attendee at meetings of the World Bank and IMF
  • Soros met Indonesian finance minister Mar’ie Muhammed at the New York Plaza hotel during the Indonesian financial crisis
  • Soros traveled to South Korea in 1998 as the guest of president-elect Kim Dae-jung
  • In June 1997, Soros received a “secret request” for emergency funding from the Russian government, which resulted in him lending the Russian government several hundred million dollars
  • Soros also had the ear of David Lipton, the top international man at the US Treasury, and Larry Summers, number 2 at the Treasury, and Robert Rubin, the Treasury secretary, as well as Mitch McConnell, a Republican Senator

Julian Robertson – “Top Cat”

  • Managed a portfolio of money managers, “Tigers”
  • Used fundamental and value analysis
  • Once made a mental note to never buy the stock of an executive’s company after watching him nudge a ball into a better position on the golf green
  • Robertson was obsessed with relative performance to Soros’s Quantum Fund
  • Called charts “hocus-pocus, mumbo-jumbo bullshit”
  • Robertson didn’t like hedging, “Why, that just means that if I’m right I’m going to make less money”
  • High turnover amongst analysts, many fired within a year of hiring
  • Tiger started with $8.5M in 1980
  • A 1998 “powwow” for Tiger advisers saw Margaret Thatcher and US Senator Bob Dole in attendance
  • Tiger assets peaked in August 1998 at $21B and dropped to $9.5B a year later, $5B of which was due to redemptions (Robertson refused to invest in the tech bubble)

Paul Tudor Jones – “Rock-And-Roll Cowboy”

  • Jones started out as a commodity trader on the floor of the New York Cotton Exchange; started Tudor Investment Corporation in 1983, in part with an investment of $35,000 from Commodities Corporation
  • “He approached trading as a game of psychology and high-speed bluff”
  • Superstition: “These tennis shoes, the future of this country hangs on them. They’ve been good for a point rally in bonds and about a thirty-dollar rally in stocks every time I put them on.”
  • Jones was a notorious chart reader and built up his theory of the 1987 crash by lining up recent market charts with the 1929 chart until the lines approximately fit
  • Jones was interested in Kondratiev wave theory and Elliott wave theory
  • “When you take an initial position, you have no idea if you are right”but rather you “write a script for the market” and then if the market plays out according to your script you know you’re on the right track
  • Jones made $80-100M for Tudor Investment Corp on Black Monday; “The Big Three” (Soros, Steinhardt and Robinson) all lost heavily in the crash
  • Jones, like Steinhardt, focused on “institutional distortions” where the person on the other side of the trade was a forced seller due to institutional constraints
  • Jones once became the catalyst for his own “script” with an oil trade where he pushed other traders around until they panicked and played out just as he had predicted
  • PTJ never claimed to understand the fundamental value of anything he traded
  • PTJ hired Sushil Wadhwani in 1995, a professor of economics and statistics at the LSE and a monetary policy committee member at the Bank of England
  • PTJ’s emerging market funds lost 2/3rd of their value in the aftermath of the Lehman collapse

Stanley Druckenmiller – “The Linebacker” (my title)

  • Druckenmiller joined Soros in 1988; while Soros enjoyed philosophy, Druckenmiller enjoyed the Steelers
  • He began as an equity analyst at Pittsburgh National Bank but due to his rapid rise through the ranks he was “prevented from mastering the tools most stock experts take for granted” (in other words, he managed to get promoted despite himself, oddly)
  • Survived crash of 1987 and made money in the days afterward
  • Under Druckenmiller, Quantum AUM leaped from $1.8B to $5B to $8.3B by the end of 1993
  • Druckenmiller stayed in touch with company executives
  • Druckenmiller relied on Robert Johnson, a currency expert at Bankers Trust, whose wife was an official at the New York Fed, for currency trade ideas; Johnson himself had once worked on the Senate banking committee and he was connected to the staff director of House Financial Services Committee member Henry Gonzalez
  • Druckenmiller was also friends with David Smick, a financial consultant with a relationship with Eddie George, the number 2 at the Bank of England during Soros and Druckenmiller’s famous shorting of the pound
  • Druckenmiller first avoided the Dot Com Bubble, then jumped aboard at the last minute, investing in “all this radioactive shit that I don’t know how to spell”; he kept jumping in and out until the bubble popped and he was left with egg on his face, ironic because part of his motivation in joining in was to avoid losing face; Druckenmiller had been under a lot of stress and Mallaby speculates that “Druckenmiller had only been able to free himself by blowing up the fund”

David Swensen & Tom Steyer – “The Yale Men”

  • Swensen is celebrated for generating $7.8B of the $14B Yale endowment fund
  • Steyer and his Farallon fund were products of Robert Rubin’s arbitrage group at Goldman Sachs; coincidence that Rubin proteges rose to prominence during the time Rubin was in the Clinton administration playing the role of Treasury secretary?
  • Between 1990 and 1997 there was not a single month in which Steyer’s fund lost money (miraculous)
  • Farallon somehow got access to a government contact in Indonesia who advised Bank Central Asia would be reprivatized soon and Farallon might be able to bid for it
  • Some rumors claimed Farallon was a front for the US government, or a Trojan horse for Liem Sioe Liong (a disgraced Indonesian business man); it is curious that Yale is connected to the CIA, Farrallon is connected to Yale

Jim Simons & Renaissance Capital – “The Codebreakers”

  • Between the end of 1989 and 2006, the flagship Medallion fund returned 39% per annum on average (the fund was named in honor of the medals Simons and James Ax had won for their work in geometry and number theory– named in honor of an honor, in other words)
  • Jim Simons had worked at the Pentagon’s secretive Institute for Defense Analyses (another possible US intelligence operative turned hedgie?)
  • Simons strategy was a computer-managed trend following system which had to be continually reconfigured due to “Commodities Corporation wannabes” crowding the trades by trending the trends
  • Simons looked to hire people who “would approach the markets as a mathematical puzzle, unconnected to the flesh and blood and bricks and mortar of a real economy” (this is distinctly different than the Graham/Buffett approach, and one wonders how this activity is actually economically valuable in a free market)
  • “The signals that we have been trading without interruption for fifteen years make no sense. Otherwise someone else would have found them.”
  • Renaissance treated employee NDAs like a wing of the CIA– anyone who joined could never work elsewhere in the financial industry afterward, and for this reason they specifically avoided hiring from Wall St in the first place; they were required to invest a fifth of their pay in the Medallion Fund and was locked up as bail payment for four years after they departed (money hostage)

David Shaw & D.E. Shaw

  • Began trading in 1988, the same year as the Medallion fund
  • Shaw was originally hired by MoStan in 1986 into their Analytical Proprietary Trading unit which aimed at beating Steinhardt at his block-trading game using predictive computer technology
  • In 1994, Shaw’s 135-member firm accounted for 5% of the daily turnover on the NYSE
  • Jeff Bezos, of Amazon, was originally a DE Shaw employee
  • The strategy was heavily reliant on pair-trade “arbitrage”, looking for securities in similar industries which were temporarily misaligned in price/multiple
  • Circle of competence: in 1995 the firm launched the ISP Juno Online, as well as FarSight, an online bank and brokerage venture

Ken Griffin & Citadel

  • Created in 1990, grew to $15B AUM and 1400 employees by 2008
  • Griffin’s goal was to develop an investment bank model that could compete with traditional, regulated ibanks, but which was actually a hedge fund
  • Flagship funds were down 55% at the end of 2008, losing $9B (the equivalent of two LTCMs)

John Paulson

  • Paulson graduated from HBS in 1980 and went to work for Bear Stearns; he launched his hedge fund in 1994 with initial capital of $2M which grew to $600M by 2003; by 2005 he was managing $4B
  • Paulson’s main strategy was capital-structure arbitrage
  • He looked for “capitalism’s weak spot”, the thing that would blow up the loudest and fastest if the economy slowed even a little; cyclical industries, too much debt, debt sliced into senior and junior tranches, risk concentrated
  • Paulson spent $2M on research related to the US mortgage industry, assembling a proprietary database of mortgage figures and statistics
  • Many of Paulson’s investors doubted him and threatened to pull capital in 2006
  • Paulson enlarged his bets against the mortgage market through derivative swaps on the ABX (a new mortgage index) and eventually acquired over $7.2B worth of swaps; a 1% decline in the ABX earned Paulson a $250M profit, in a single morning he once netted $1.25B
  • By 2007, he was up 700% net of fees, $15B in profits and made himself $3-4B

Conclusion

I’m actually even more bored with this book having finished typing out my notes than I was when I finished the book the first time I read it. The book actually has some great quotes in it, from the insane delusions of grandeur of government officials and central bank functionaries, to wild facts and figures about the statistical trends of the hedge fund and financial industries over the last 60 years. I am too exhausted to go back and type some of it out right here even though I kind of wish I had some of the info here even without an idea of what I’d use it for anytime soon.

My biggest takeaway from MMTG is that most of these masters of the universe have such huge paydays because they use leverage, not necessarily because they’re really good at what they do. Many of their strategies actually involve teasing out extremely small anomalies between asset prices which aren’t meaningful without leverage. And they’re almost uniformly without a meaningful and logically consistent understanding of what risk is– though many are skeptics of EMH, they seem to all see risk as volatility because volatility implies margin calls for levered traders.

There were so many displays of childish superstition. Many of these guys are chart readers. The government intelligence backgrounds of many was creepy. And it was amazing how many relied on informational asymmetries which are 100% illegal for the average investor. These people really travel in an elite, secretive world where everyone is scratching each other’s backs. How many one on one conversations have you had with central bank presidents? How many trips to foreign countries have you been on where you were the invited guest of the head dignitary of the country? Are you starting to put the picture together like I am?

Overall, it seems so arbitrary. The best word that comes to mind to describe these titans and their success is– “marginalism”. We have lived in an inflationary economy for the last 60+ years and these players all seem to excel in such an environment. But inflationism promotes marginalism; the widespread malinvestment of perpetual inflation confuses people looking to engage in real, productive economic activity, and paper shuffling necessarily becomes a high value business.

The author himself is incredibly ignorant of economic fundamentals and the role monetary intervention plays in the economy. All of the various crises these hedgies profited from seem to come out of nowhere according to his narrative. The incredible growth in volumes of money managed by the hedge fund industry over time goes without notice, as if it was just a simple, unexceptional fact of life. Shouldn’t that be interesting? WHY ARE THERE HUNDREDS OF FIRMS MANAGING TENS OF BILLIONS OF DOLLARS EACH? Where did all this money come from?!

That makes the book pretty worthless as it’s key.

One thing that does strike me is that many of the most successful, most levered trades of Soros, Druckenmiller and others were related to currencies. These guys are all Keynesians but they probably don’t fully believe their own economic theories. However, they do understand them well enough to make huge plays against the dope money managers who DO put all their credence into what they learned at university. I should think an Austrian econ-informed large cap macro fund would have quite a time of it playing against not only the dopes, but the Soroses of the world– they’ll get their final comeuppance as this system of artificial fiat exchange finally unwinds over the next decade.

And, little surprise, the guy with the nearly perfect trading record for almost a decade (Farrallon) was involved in arbitrage trades.

Trend following is for slaves. It may have proven to be a profitable strategy (with gobs of leverage) for the contemporary crop of hedgies but I feel fairly confident in saying most of these guys will get hauled out behind the woodshed in due time if they keep it up, to the extent their strategies truly are reliant on mystic chart reading and nothing more.

Bon voyage!

Notes – There’s Always Something To Do

There’s Always Something To Do: The Peter Cundill Investment Approach

by Christopher Risso-Gill, Peter Cundill, published 2011

The Peter Cundill approach to value investing

The following note outline was rescued from my personal document archive. The outline consists of a summary of Christopher Risso-Gills’ recent biographical investment profile of Canadian value investor Peter Cundill, There’s Always Something To Do. The notes are in summary form of the most critical aspects to Cundill’s value investment perspective and analytical process.

There’s Always Something to Do: The Peter Cundill Investment Approach

  • “I think that intelligent forecasting should not seek to predict what will in fact happen in the future. Its purpose ought to be to illuminate the road, to point out obstacles and potential pitfalls and so assist management to tailor events and to bend them in a desired direction.”
  • He made a habit of visiting whichever country had the worst performing stock market in the past 11 months.
  • “In a macro sense, it may be more useful to spend time analyzing industries instead of national or international economies.”
  • “It must be essential to develop and specify a precise investment policy that investors can understand and rely on the portfolio manager to implement.”
  • A few investment principles:
    • never use inside information, “All you get from inside information is a whiff of bad breath.”
    • economic facts and company values always win out in the end
    • don’t try to be too clever about the purchase price
    • isolate what the real assets are
    • never forget to examine the franchise to do business
  • Insider buying is not always well-informed– Peter once scooped up shares of J. Walter Thompson (JWT) at a perceived discount and faced a hostile and confused president who was selling stock from the companies pension fund and couldn’t figure out why Cundill was buying (pg. 29), which demonstrates that there are informational disadvantages and ambiguities that keen analysts can take advantage of, even over company insiders; insider buy/sell ratios and actions should be considered thoughtfully and fully “discounted”, not taken as authoritative proof of anything by themselves
  • “Very few people really do their homework properly, so now I always check for myself.”
  • Look for hidden gems on the balance sheet
  • Investing globally:
    • if you find one foreign stock that is trading at a significant discount, snoop around because there may be other bargains in the foreign industry or market
    • There was nothing “ad hoc” about the way Peter addressed the process of international value investment. In every instance it had to be firmly based on a clear understanding of local accounting practices and how those might differ from accepted standards in North America. The fact that it was different, less transparent, or deliberately opaque was never a reason for ignoring or excluding a market or security. Peter’s attitude was “vive la difference”; if a balance sheet was hard to penetrate it was not just a challenge but an opportunity because the difficulties actually represented a “barrier to entry” even for the experienced professional investor and undoubtedly excluded all but the most sophisticated private investors.
    • The other aspect, which Peter considered to be a vital component of a successful international strategy, was building carefully constructed networks of locally based professionals who had a thorough understanding of value investment principles and would instinctively recognize a security that would potentially fit the Cundill Value Fund’s investment criteria.
  • “THE MOST IMPORTANT ATTRIBUTE FOR SUCCESS IN VALUE INVESTING IS PATIENCE, PATIENCE AND MORE PATIENCE. THE MAJORITY OF VALUE INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.”
  • “It is also dangerous to rely on a single strategy in a doctrinaire fashion. Strategies and disciplines ought always to be tempered by intelligence and intuition.”
  • Personal margin note: Peter did not succeed in isolation but cultivated and utilized networks of knowledgeable and influential people (investors, political activists and politicians, business people); he also had several mentors
  • Peter was impressed by a group of corporate socialites he had dinner with, “They maintain that having a hangover is a waste of a day.”; personal margin note: respect the value of time, the ultimate scarce resource, always
  • Peter organized a prestigious investment conference, the Cundill Conference, where he both talked and exchanged ideas on investing with other friends and gurus, as well as heard from invited guest expert speakers who spoke on a range of topics totally unrelated to investing, to promote cross-disciplinary rigor and creative spark
  • “The boards of charitable foundations are convenient meeting places for influential people. Their ostensible purpose is intimately bound up with the social and commercial ones.”
  • Peter relocated to London from Toronto to better pursue his global value investment approach, seeing London as the center of capital and the business crossroads of the world at the time; personal margin note: where is today’s London, or tomorrow’s?
  • On flying across the Atlantic routinely on the Concorde:
    • “It is a remarkable sounding board, especially in my world of matters financial.”
    • “One becomes even more keenly aware that there is never just one factor determining events, there are many of them interwoven and acting simultaneously.”
    • “I always need to discipline myself to be aware of the world generally, rather than trying to be specific. I only need to be specific about the numbers.”
  • Selling stocks which near or surpass their intrinsic value often acts as an “inbuilt safety valve” for the value investor in markets which are in a bubble or overpriced generally
  • Peter channels Horace’s Ars Poetica via Graham in a journal entry prior to the 1987 Crash: “Many shall be restored that now are fallen, and many shall fall that are now held in honor.”
  • “Sooner or later the market will do what it has to do to prove the majority wrong.”
  • Cundill, via Oscar Wilde, on an approach to stocks: “Saints always have a past and sinners always have a future.”
  • “Being out on a limb, alone and appearing to be wrong is just part of the territory of value investment.”
  • Cundill on overvalued markets: “it can tempt one to compromise standards on the buy side and it may lure one into selling things far too early.”
  • Cundill’s value approach gently evolves: “Discounts to asst value are not enough, in the long run you need earnings to be able to sustain and nurture these corporate values. We now, as a matter of course, ask ourselves hard questions as to where we expect each business to be in the future and, as well, make a judgment on the quality of management.”
  • Cundill defines shorting based off of his ‘antithesis of value’: “identifying a market where values are so stretched and extreme that they are clearly unsustainable. They have passed far beyond the realms of any measure of statistical common sense.”
  • “The great records are the product of individuals, perhaps working together, but always within a clearly defined framework.”
  • “In reality outstanding records are made by dictators, hopefully benevolent, but nonetheless dictators.”
  • On avoiding the temptation to sell an eventual winner: “What we ought to do is go off to Bali or some such place and sit in the sun to avoid the temptation to sell too early.”
  • Cundill on his shock related to 1968 sentiment toward the shoddy accounting of the conglomeration movement: “Nobody cared; accounting is a bear market phenomenon!”
  • “Every company ought to have an escape valve: inventory that can readily be reduced, a division that can be sold, a marketable investment portfolio, an ability to shed staff quickly.”
  • “We always look for the margin of safety in the balance sheet and then worry about the business.”
  • “If there’s no natural skeptic on an investment maybe it would be wise to appoint one of the team to play Devil’s Advocate.”
  • More on investing overseas in developing markets: What was required was an asset-based margin of safety significantly greater than would be considered adequate in the more developed markets. It was also fairly obvious that in these less developed markets tangible fixed assets were superior to cash, which had a nasty habit of evaporating.
  • Cundill on retirement: “Retirement is a death warrant.”
  • Poetic Cundill: “No fortunes are made in prosperity, Ours is a marathon without end: Enjoy the passing moments.”
  • Cundill’s wit and wisdom on what makes for a great investor:
    • “Curiosity is the engine of civilization”, he advises to have serious conversations with people that result in an exchange of thoughts and to keep one’s reading broad.
    • “Patience, patience and more patience.”
    • “Always read the notes to a set of accounts very carefully… seeing the patterns will develop your investment insights, your instincts — your sense of smell. Eventually it will give you the agility to stay ahead of the game, making quick, reasoned decisions, especially in crisis.”
    • “Holding on to a heavily discounted stock that the market dislikes for a period of five or ten years is not risk free. As each year passes the required end reward to justify the investment becomes higher, irrespective of the original margin of safety.”
    • “An ability to see the funny side of oneself as it is seen by others is a strong antidote to hubris.”
    • Routines: “They are the roadmap that guides the pursuit of excellence for its own sake.”
    • Via Peter Robertson, “always change a winning game.”
    • “An investment framework ought to include a liberal dose of skepticism both in terms of markets and of company accounts.”
    • Personal responsibility: “If you lose money it isn’t the market’s fault… it is in fact the direct result of your own decisions. This reality sets you free to learn from your mistakes.”
    • Suggested reading list:
      • Extraordinary Popular Delusions and the Madness of Crowds
      • The Crowd: A Study of the Popular Mind
      • Buffett: The Making of an American Capitalist
      • The Money Masters
      • The Templeton Touch
      • The Alchemy of Finance
    • Cundill’s Corrolary to Murphy’s Law: “When things get so bad that you’re really scared, that’s the time to buy.”
    • Global investing: “Given the dearth of bargains today, it pays to search for them everywhere.”
    • On independence, via Ross Southam, “You have to be willing to wear bellbottoms when everyone else is wearing stovepipes.”
    • “If it is cheap enough, we don’t care what it is.”
    • “I would say that the problem with big businesses that have moats around them is they tend to over-expand.”
    • “IPOs for the most part are dreams engendered by the hope that pro forma estimates will be met. We deal to a certain extent in nightmares that everyone knows about.”
  • Three parts to Cundill’s investment strategy:
    • NAV
    • sum of the parts analysis
    • future NAV estimation
  • “Sometimes nothing is more misleading than personal experience.”
  • Investments held by Peter Cundill, managed by others, a potential place to search for ideas or gain more insight, pgs. 223 and 224