Probabilities, Process, and Outcomes 2020 4Th Quarter Commentary, Review, and Outlook
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Q4 2020 Commentary, Review, & Outlook Investment Management Probabilites, Process, and Outcomes Robert G. Hagstrom, CFA Chief Investment Officer Senior Portfolio Manager Investment Commentary Robert G. Hagstrom, CFA Chief Investment Officer Senior Portfolio Manager January 5, 2021 Probabilities, Process, and Outcomes 2020 4th Quarter Commentary, Review, and Outlook “Your focus has to be on process, because that is the only thing that you can control. So your process has to be as good as it can possibly be. But you have to constantly revisit your process because...the world is always changing.” (1) —Maria Konnikova, Author, Psychologist, Poker Champion Commentary indicate a broken process. In poker they call it a “bad run of the cards.” It also happens in the The intellectual distance between playing cards stock market. Every investor has experienced a and investing in the stock market is not wide. period when the ticker-tape moves against one’s Both require decision-making based on portfolio. incomplete information. Even so, card games and the stock market have just enough information for A good process sometimes endures a bad one to estimate the probability of being right or outcome. Robert Rubin, former U.S. Treasury wrong and to act accordingly. Indeed, Secretary said it best. “Any individual decision probabilistic thinking is the concentric circle that can be badly thought through, and yet be links card playing and investing. successful (called dumb luck), or exceedingly well thought through, but be unsuccessful (referred to Many professional investors are likely to have a as a bad break). But over time, more thoughtful copy of David Sklansky’s classic book, The Theory decision-making will lead to better overall results, of Poker, next to Graham and Dodd’s seminal and more thoughtful decision-making can be book on investing, Security Analysis. Now encouraged by evaluating decisions on how well investors are adding to their library Maria they were made rather than on outcome.” (2) Konnikova’s new book, The Biggest Bluff: How I Learned to Pay Attention, Master Myself, and Win. Konnikova correctly states, “your process has to What makes Konnikova’s book popular is that she be as good as it can possibly be.” But perhaps succeeds in the world of high-stakes poker— the most important advice is what she said next. specifically, No-Limit Texas Hold’em—not as a “You have to revisit your process because the seasoned poker player who spent a decade plus world is constantly changing.” playing in poker tournaments, but as a novice Beginning with online poker tournaments in a who happens to be have a Ph.D. in psychology. coffee shop in Hoboken, New Jersey in 2016 to Konnikova discovered the most successful becoming the PCA National Champion in 2018 tournament poker players focus on the process of could not have occurred unless Konnikova was making good decisions rather than obsessing willing to work on her process. As she moved up over busted hands and missed opportunities. the poker rankings, it became clear the games (1) Max, Sarah. “Here’s Having studied some of the most successful were changing because the players had Some Investment Advice investors in history, I have observed the best changed. In a word, the players were getting from Psychologist and portfolio managers also focus on process while smarter. Poker, like the stock market, is a Poker Star Maria Konnikova: Focus on your spending little time, if any, dwelling on short-term dynamical system that is constantly learning, Decision-Making losses. Konnikova is exactly right—the only thing evolving, and adapting. For this reason, Process.” Barron’s, 11 you can control is your process knowing full well Konnikova knew that in order to become Dec. 2020. outcomes are variant. successful she would have to improve her game— (2) Rubin, Robert. and it eventually paid off. Had she not continually Harvard University Periodic bad outcomes in poker tournaments, Commencement Address, refined her process, Konnikova may never have and in the stock market alike, do not necessarily 2001. become a poker tournament champion. 2 Probabilities, Process, and Outcomes 4Q 2020 Commentary, Review, and Outlook Investment Commentary How does this relate to investing? Most investors achieve hundreds of billions of dollars in market who attain a level of success adopt what is called value with but a fraction of the capital needed to a “correspondence theory of truth.” Having grow compared to the brick and mortar industrial achieved market-beating returns, these investors companies of yesteryear. believe their approach—their investment Today, the most optimal business strategies are process—corresponds to some deep, well- asset-light models. As such, book value as a founded structure of how markets operate. As signal for selecting stocks has become less such, the tendency among these investors is to important. Although cash earnings remain the repeat, over and over, the same investment bedrock signal for value creation, investors have process that led to their success. This is all well also learned sales growth, combined with high and good as long as the market does not change. returns-on-invested-capital (ROIC), have become But what happens when the economy and the turbo charger for increasing a company’s markets change? intrinsic value. What is unmistakable are the methods used to select stocks during the Over the last 100 years, since the first Model-T industrial age are no longer as useful for picking rolled out of the Ford plant in Detroit in 1908, our stocks here in the fifth technological revolution. economy has evolved from an industrial-based, brick and mortar world to a consumer-based, Successful, long-term investors are dynamic service-driven economy, to now having entered thinkers. And that is a good thing because the the fifth technological revolution called the Age stock market is dynamic. Long-term investors of Information and Telecommunications. (3) The understand the world is changing and the principles of the fifth technology revolution “challenge of change” requires adaptation. include information intensity and globalization. Knowing this, investors who want to be Information intensity means knowledge as capital successful, like Maria Konnikova, must become is the value added. learning machines. The most accomplished investors reject hiding behind outdated models Now think back to the investment process used and instead embrace pragmatism as a way to during the Industrial Revolution. For the first 70 “widen the field of search” for ideas that can help years of the twentieth century, picking stocks was them become better investors. largely an exercise of buying companies that were trading at prices below book value while At EquityCompass, we have learned the highest avoiding stocks that were selling at prices above achieving investors are those who continually book value. It was an investment process that work to improve their process. This lesson is not worked exceedingly well for a long period of lost on us. Although EquityCompass and our time. However, when our economy evolved to a clients are the beneficiaries of what we have consumer-based, less capital-intensive economy, learned thus far, we remain open minded and book value was less useful in determining receptive knowing full well that there will be intrinsic value. Successful investors turned to more to learn about investing in the years ahead. calculating the growth of cash earnings as they Review discovered this was a better method for selecting stocks. These investors improved their process Many agree, 2020 was a year that will not soon and hence, improved their investment returns. be forgotten. Although countless are still reeling from the acrimonious Presidential election, We have now entered the second half of the fifth politics do come and go, but the scars left by the technological revolution called the “deployment COVID-19 global pandemic will be more long period.” It is a time when new technology lasting. companies have finally achieved coherent growth based on new customers. Increasing real Millions of people around the world have lost (3) Perez, Carlota. economic returns in the form of sales and cash loved ones to the coronavirus. Many millions Technological Revolutions earnings have become evident. What we have more have suffered debilitating economic and Financial Capital: the hardships that seemed unimaginable 12 months Dynamics of Bubbles and discovered is the leading companies in the fifth Golden Ages. Edward Elgar, technological revolution have been able to ago. Here in the U.S., 10 million who have lost 2014. January 2021 3 Investment Commentary their jobs because of the pandemic have not yet The third force that worked to resuscitate the been rehired. Everywhere one looks, both large stock market was the above-average growth of a and small businesses have been shuttered, select group of companies that had become the unable to survive in a social distancing economy unexpected beneficiaries of the economic that has rewritten consumer behavior. When it is lockdown. Although many companies in the all said and done, 2020 will go into the history travel, leisure, and entertainment industries were books as the worst U.S. economic year since The penalized by the pandemic, there were a great Great Depression. number of companies that have thrived Even so, all major stock indices have reached throughout the lockdown. Companies in the historic highs this year despite an economy that is technology and telecommunications industries still 5% below its 2019 level. What best explains achieved high growth rates because employees this financial conundrum? Looking back, we had to conform to new work-at-home rules. believe the buoyancy of stock prices in 2020 can Additionally, the amount of time individuals and be attributed to three separate forces. their families previously spent shopping at malls, going to movie theatres, and dining out was First was the quick action of the Federal Reserve replaced by online shopping, home deliveries, (Fed) to cut interest rates to the zero bound and and Internet streaming of television shows and then inject trillions of dollars into the capital movies.