Friday, January 23, 2009

Black Swan Hunting

In my years as an investor and a professional in the financial services industry, I have not yet been able to find anyone who can accurately and consistently forecast future market events with any degree of accuracy. In my view, any and all forecasts are, at best, educated guesses. Many brokerage houses and investment banks have literally dozens of in-house economists that dedicate their careers to identifying changes in the economy before they happen, when in reality we have found that, no one truly knows what tomorrow will bring. In a survey of Wall St. economists taken one year ago, the "consensus" view was that the likelihood of recession was less that 40%. One problem with these forecasts is known as the "Black Swan Theory", popularized in a book by Nassim Nicholas Taleb, that recounts a 17th century scientific experiment as a metaphor for a deeper philosophical question about human behavior. In the book he argues that we place too much weight on the odds that past events will repeat, using statistics and the scientific method. Instead, the most impactful events are those that are rare and unpredictable. Aside from their obvious human tragedy, events occurring in the last decade such as the tech/telecom bust, 9/11, hurricanes of 2004, and the current credit crisis have been powerful examples of highly improbable events that have had a profound impact on history and our portfolios.

While I would agree with his conclusion, I would argue that there are 2 kinds of predictions that, when applied consistently, have some value to investors and should be considered in the investment process: One is opportunity-based, and the other is risk-based. Risk based forecasts are applied extensively in the asset allocation process. First and foremost, when constructing and maintaining portfolios I believe that by applying a consistent and disciplined strategy balancing growth, income, and alternative asset classes you can successfully reduce exposure to inflation, currency devaluation, credit risks, and declines in corporate and consumer spending. While we can add value by tilting these beta exposures in response to cyclical and fundamental changes, anchoring the portfolio from these risks increases the likelihood of long term success of the strategy. One tool used in determining these allocations is known as "Monte Carlo" analysis, in which a computer effectively recreates over 10,000 portfolio outcomes or "rolls of the dice" in order to effectively determine which weightings are most appropriate, Because a "black swan" can have such a large impact on our portfolios, and are so as hard to predict, we should continue to embrace diversification.

Probability assessments are typically based upon historical comparisons of prior markets with similar characteristics: The more variables that align, the higher the likelihood that a given scenario plays out in a similar fashion. While I admittedly did not anticipate the magnitude and depth of the current crisis, I have been, and continue to strategically position assets away from financial, consumer discretionary, and cyclical industries, in favor of increased weighting toward healthcare, staples, and utility stocks, which are generally a safe haven during periods of market duress. Many times these types of comparisons require going back in time, to make a thoughtful judgement about the future. A recent decision to sell a position in Schlumberger (SLB) was based on an analysis of the oil services industry and its sensitivity to economic events that happened in 1974 and 1981.

Another way to improve the likely outcome of the portfolio can be seen within the research process itself. As access to credit and free flowing spigot of the capital markets becomes sealed temporarily, I have rigorously approached each holding as "credit analyst" would, rather than simply an equity analyst. Reviewing debt covenants, credit facilities, and near-term spending needs for each company owned has become routine. I am highly confident that these actions have minimized risk, and recent additions to the portfolio like Alcon, Stryker, and Google, further improve quality of the portfolio with their pristine balance sheets and strong cash generating ability.
Probability assessments are not only used as a defensive mechanism, but also as tool used in search for opportunities within your investment universe. To illustrate this concept consider an investor with the following investment opportunities presented to him/her: Opportunity A) a $1mm investment that offers a 20% return, with an 80% likelihood of success. Opportunity B) a $1mm initial investment with a payoff of 50%, but only a 50% likelihood of success. At first glance, most people would pick opportunity A, because if its relative certainty, but a more informed investor would actually pick the second opportunity, because the probability weighted expected value is actually higher (250k vs. 160k). This type of analysis is used extensively when evaluating an E&P company with a portfolio of oil or gas reserves, with differing levels of profitability and probability of drilling project success.

When thinking about constructing your portfolio in a way that is aligned with your view of the world, it is important to have an investment paradigm or framework in place to guide decision making in a disciplined and consistent manner. Mohammed El-Erian, former manager of the Harvard Endowment, and currently a bond portfolio manager at Pimco, uses the analogy of a 6 lane highway, to illustrate how to benefit from our perceived systemic changes to the investment landscape. He believes that investors can benefit by identifying a handful of growth themes (lanes of highway) in a portfolio, that may take several years to materialize, but investor can shift vehicle to avoid traffic (risk exposures) but needs to stay within the highway barriers (investment process). Within the framework of an investment process, we can add value in a similar fashion.

In the near term I anticipate weak consumer and corporate spending environment, however, recently announced government stimulus programs around the world may offset some of this weakness. President Obama recently announced a $700B program designed much like the "New Deal" with huge investments in transportation, telecommunications, healthcare, and power grid infrastructure, are likely to benefit many of our holdings. Norfolk Southern should benefit from improvements to the nations rail network; companies like Cisco Systems, Citrix, and Google will benefit from the "networking" of America's schools and institutions, and names like ABB and ITT will surely benefit from increased spending on infrastructure and energy efficiency.
While none of us has a clear “crystal ball” to foretell the outcome of current economic situation, history tells us that it is likely to be longer and more complex than most people anticipate, and controlling risk needs to remain the top priority in your portfolio. That said, with risk comes opportunity. Many of the darkest, most uncertain times in our history, were times that presented the greatest opportunities for investors. We continue to strive to find those opportunities without taking unnecessary or excessive risk.