ABOVE ALL

THE DELUSION OF EXACTITUDE

Or, SEDUCED BY EXCEL SPREADSHEETS

Yesterday the almost 10% decline in the market value of Walmart (the largest one day decline in approximately 15 years for that stock) and the associated spillover impact in the broader market is an excellent illustration of one of my favorite theses; viz, that there is a tendency by most analysts and investors to spend too much time on the detailed analysis of data rather than developing broader insights. (It is often helpful to spend more time on developing an understanding of the forest rather than getting lost among the trees.)

Four facts relevant to this changed forecast of the Walmart earnings outlook were widely known for months prior to the abrupt stock price decline.  First, that for several reasons Walmart had decided to aggressively raise the pay of its employees over the next three years. Second, that the company has a new CEO who probably views a relatively long time frame as the appropriate period for measuring the success of his efforts to reposition the brand and respond to the challenges that had recently slowed its growth. Third, that one of those major challenges was the continuing impact on traditional retailers of Amazon in particular and the growth of on line retailing in general. Fourth, that in addition to the “investment” in their personnel there would be additional investments in infrastructure and probably in price competitiveness (that is, lower prices and the associated margin impact). So, why was the cumulative impact of these factors so misjudged? I would posit that while there are several reasons, two are probably dominant.  First, undoubtedly an important one is that when very long established trendlines change in a business’ trajectory, the initial tendency is usually to underestimate the resultant impact. (An analogy in another context would be the belief that residential housing values would always increase and the resultant chaos from the very belated recognition of the fact that the value of financial instruments structured with a reliance on that belief could be negatively impacted.) However, in my view, probably the most important reason is a function of the analytical methodology now almost universally utilized in the development of very detailed spreadsheets to forecast corporate cash flow and earnings per share.  These forecasts by necessity involve incorporating assumptions that are much less reliable than is explicitly recognized. Subsequently, valuations are projected based on models utilizing these forecasts. Each of these steps introduces additional uncertainty, but the cumulative nature of that uncertainty becomes easily ignored. The focus on the trees in the forest of data and the information extracted from it has substituted for an attempt to derive insights from the totality of the forest of more subjective and less quantifiable information readily available. Perhaps my training as an actuary and statistician allows me to more clearly understand the risks and limitations of such an approach, and to always understand that while the phrase “garbage in, garbage out” may be an extreme caricature of the process; it should always be kept in mind that “uncertainty in” that results in “uncertainty squared out” is invariably the outcome.

This tendency is also clearly illustrated by the periodic debacles in the junk bond and LBO markets, and as mentioned previously was a major aggravating factor in the debacle in housing finance, particularly with regard to the structured financial instruments that were developed. In all cases, the underlying assumptions utilized to develop the detailed cash flow repayment schedules always provided misplaced confidence to the holders (and guarantors) of such debt. As long as the assumptions were correct, whether of borrower cash flow or housing and other asset values, the interest and principal would be easily repaid. And the detailed spreadsheets made it appear that there was usually a substantial margin of safety even as leverage increased over time and the covenants weakened or the mortgages became “low doc” or “no doc”. But, of course, only in retrospect was the question asked - how could these assumptions have been so wrong? Yet, even a little less time spent on data collection and manipulation and more on trying to develop insights from the available information would have been much more valuable than the delusion that the data so carefully developed in the multitudinous spreadsheets involved was actually an highly accurate prediction of future reality.  Perhaps the most difficult to accept wisdom among many investors is that their knowledge is very limited and they will often be wrong, and that is why the market gets an opportunity to remind us of that fact so often, as the Walmart example has again proved.

Another of of my core beliefs which is illustrated by this episode is that there is a major distinction which needs to be drawn between the idea of an efficient market which incorporates all the data available to market participants at any given moment and the idea that market prices (either for individual stocks or in aggregate) are correctly valuing the future prospects and outlook for the securities involved. In actuality, any price equilibrium in the market is momentary and based solely on current actual and potential buyers and sellers, but it implies nothing about future liquidity and price stability or volatility. In terms of market value the largest retailer in the world (when measured by annual sales) was worth $20 Billion dollars less at the end of October 14^th than when the stock market opened that day, and we know that both estimates of the discounted future value of all cash available to stockholders (which is what the market value represents) could not actually be correct because nothing about the company had changed in that time period except the management’s financial forecasts for the next three years. In reality of course probably neither estimate is correct, but that the disparity on two consecutive days for such a well-followed stock with such a large capitalization shows why skepticism is always warranted concerning forecasts, since as Yogi Berra supposedly warned us “it’s tough to make predictions, particularly about the future”. Once again, the wisdom of Yogi has proved superior to the seemingly seductive exactitude of the conclusions in thousands of Excel spreadsheets modeling Walmart.

 October 15, 2015 

RED SOX WIN! RED SOX WIN!                                 LESSONS OF THE GAME

 As many readers of this newsletter are aware, I am a lifelong baseball aficionado and Yankee rooter who experienced intensely conflicting emotions regarding the outcome of this year’s World Series. It was of course a major disappointment to watch the 2004 Yankees guarantee their place as a unique footnote in baseball history by becoming the first team ever to lose a postseason series after leading three games to none. That totally unprecedented turn of events vividly brought home the emotional reality of how 1978 Red Sox fans undoubtedly felt when Bucky Dent hit his home run or how Braves fans felt as the Yankees staged their amazing comeback in game three of the 1996 World Series and then swept the next three games as inexorably as the Red Sox executed their eight game win streak this postseason. My initial disappointment was greatly ameliorated, however, not only by the fact that my wife, a lifelong Red Sox fan had finally experienced an end to her years of frustration, but also by an actual feeling of excitement concerning the implications of this truly historic postseason achievement by the Sox. After the years of frustration since 1918 (including losing all four of their subsequent appearances in the World Series – 1946, 1967, 1975 and perhaps most heartbreakingly 1986 - in the seventh and deciding game), the supposed “curse” had been decisively vanquished and there was managerial strategy to be endlessly debated, lessons to be analyzed and conclusions to be drawn.

This issue of the ABOVE ALL newsletter will attempt to relate the relevance of this historic sports achievement by the Red Sox to the investment and business sphere. By way of explanation, I firmly believe that the use of analogy is a very powerful educational tool which often allows the insights assembled from the experiences in one area to be effectively applied in seemingly unrelated circumstances. Of course, there is a risk that the analogy utilized is inappropriate or the lessons drawn incorrect. Despite these potential problems, I believe that this technique is too potentially valuable and too good a teaching tool to forego. Upon reflection, readers of this newsletter will probably realize how intertwined sports analogies are with many aspects of our lives; they have become totally interwoven into the idiom of many investment and business discussions to the extent that they need no explanation and their appropriateness is unquestioned. (E.g., the frequent use of the question – what inning is the bull or bear market in currently? This attempt to quantify how much of the “game” is left to play is in fact often used inappropriately or at least frequently elicits misleading and unhelpful answers; however, that is a topic for another day.) The following discussion attempts to provide some useful insights to both the most rabid baseball enthusiasts as well as casual observers of the national pastime.

One obvious but nevertheless important lesson to be learned is summarized by the wisdom encapsulated in Yogi Berra’s immortal truism – “It’s not over until it’s over”. Or as Kenny Rogers so succinctly captures the same sentiment in his signature song THE GAMBLER – “Never count your money while you’re sitting at the table, there’ll be time enough for counting when the dealing’s done”. It’s always important to remember that momentum can quickly change from being the wind at your back to the hurricane in your face; it is a factor which often provides the maximum amount of confidence to an investor (or a fan, or a baseball bettor) at exactly the wrong time. To continue in the Kenny Rogers’ idiom, after a run of good luck, it’s often time to take some money off the table even if you don’t want to leave the game; it’ll make you feel a lot better when you find yourself “out of aces” and have to rely on successfully drawing to an inside straight. The advantage of hedging your bets after a long winning streak was certainly a powerful lesson learned too late by many investors who became overnight (albeit temporary) millionaires at the height of investor enthusiasm about the seemingly unlimited potential of the internet.

A less obvious and much less appreciated and but probably more important lesson is that history and experience provide at best an approximation (and frequently a very poor one)  for the real odds of the occurrence of any particular event. Unless the historical circumstances involved are truly identical to those used to calculate the projected odds of the outcome of a superficially similar event, it is easy to be misled by the false sense of scientific accuracy implied by an exact mathematical representation. While baseball fans knew that no team before this year’s Red Sox had ever come back to win a seven game postseason series after trailing three games to none, they did recognize that it was still a mathematical possibility. However, the odds available (roughly 19:1) against such a comeback clearly didn’t reflect the qualitative differences between the 2004 ALCS and the other post season series where one team had achieved such a commanding lead . In most prior circumstances, the team gaining the 3-0 advantage was clearly superior and was often expected to dominate the series before it began. This year, the teams were viewed as relatively evenly matched. The Red Sox probably would have been at least modest favorites due to their superior pitching except for concerns about the effect of Curt Schilling’s ankle injury on his performance. Thus, rather than the Yankee’s early success being viewed as an indication of their superiority, in retrospect it should have been seen as an opportunity for an early investor in the Yankees whose judgment seemed correct to recognize that if the initial odds were about right it was time to sell or at least reduce the position and bank most of the profits. Likewise, just when a string of successes convinces investors in an industry or traders pursuing a trading strategy that they really have sufficient data in their knowledge base to accurately assess the odds in their next investment is when they are most likely to exhibit the overconfidence that will inevitably lead to failure.

A familiar illustration of such a shift in investment psychology is the viewpoint that gradually developed in the investment community that McDonald’s had lost its business edge and was too large a battleship to easily change direction. Thus, as Wendy’s nimbleness seemed to continually erode McDonald’s customer base and brand image, it became accepted investment wisdom that Wendy’s market share gains would continue at McDonald’s expense. Thus, despite the bear market for much of the thirty nine months from year end 1999 through March 2003, Wendy’s stock price advanced 34% during that period while McDonald’s declined a horrendous 63%. (For comparative purposes, the S+P 500 Index declined 41% during this period.) Just when this trend seemed inexorable, however, the cumulative effect of the recent management and operating changes made at McDonald’s finally started to have a visible impact that could no longer be ignored by investors. As a result, from March 2003 to date Wendy’s stock price advance of 26% significantly trails the S+P 500 gain of 36% while during the same twenty months McDonald’s stock price is up an astounding 98%, thus greatly confounding those investors who believed that past performance is always the best indication of the future odds of success.

This observation leads to a third insight. Investing with the consensus at short odds usually makes it a lot more likely that you will lose money than earn a profit. After all, what was the possible edge represented by an investment in the Yankees winning the ALCS when only a little more than five percent upside remained and a loss of one hundred percent was possible? In fact, the obviously smart investment at that time was a relatively small bet on the Red Sox. If the initial odds were correct, then clearly some chance remained that they might actually stage a miraculous comeback if Schilling somehow managed to pitch well despite his injury. Meanwhile, the potential payoff of twenty times at least provided a reasonable return on your speculative investment. In summary and by way of clarification, this discussion is not meant to imply that speculative investments with the potential for high returns are good and that supposedly safe low return investments are bad. It is an attempt to remind investors that the odds (or price) always have to be an integral part of the decision process; the shorter they are (the lower the potential return), the more certain that the investor needs to be that they are both an accurate approximation of the underlying reality and that the risk of loss is minimal. When the Yankees led the ACLS series 3-0, neither of these factors were present and thus the bet was always a stupid one. Likewise, a lot of very smart people (including some Nobel laureates) miscalculated the odds of achieving large returns compared to the risk of ruin in the case of one of the most publicized investment failures in market history, Long Term Capital Management. As the Red Sox victory proves, even extremely low probability events occur and should be protected against. When the perceived risk is the greatest (on occasion even including the possibility of bankruptcy) is often when the actual risk has been minimized. This fact is true both because the price then reflects the risk and because management is in all likelihood intensely focusing on risk reduction.

The final lesson is that despite the danger inherent in betting on an event or investing in a company in the belief that “this time it’s different”, on occasion real transformation does occur. Profound change is not only possible but in the really long run probably inevitable. The ability to recognize it in a timely fashion can be extremely profitable. Of course, for years the emotional (and sometimes financial) investment of Red Sox fans in hoping that things had really changed had not been rewarded; thus, the signs of true change were skeptically received. First, new ownership arrived. Second, they hired Theo Epstein, a young GM willing to restructure the team by taking the radical step of hiring one time outsider Bill James as a consultant. He was even willing to take the risk of being second guessed by making the radical move of replacing hometown favorite and five time All Star shortstop Nomar Garciaparra with the solid but relatively unknown Orlando Cabrera. Third, the only connection of the new manager Terry Francona and most of the players to the years of failure was that they wore the Red Sox uniform; even Fenway Park itself had been transformed with the seats atop the Green Monster and other fan friendly changes which improved the team’s finances and made it more able to compete with the open checkbook of Yankee owner George Steinbrenner. In retrospect, the culture shift was probably completed with the addition of pitcher Curt Schilling. Schilling’s total dedication to his goal of being the final piece of the puzzle was evident not only in his pitching exploits throughout the season but in his obvious enjoyment of every aspect of his role, down to such details as some of the truly entertaining commercials in which he starred. He relished the challenge rather than treating it as a burden. His superb pitching performances despite the incredible pain of his sutured ankle tendon in game six of the ACLS and game two of the World Series clearly rank as two of the most inspiring performances ever accomplished in modern day professional sports championships. So remember the lesson well - new ownership, new management, a different business strategy, a revamped product line and the intense dedication of a superstar able to instill confidence within in his teammates (fellow employees) and produce a dedication to their mission can occasionally all combine to create truly meaningful change and unexpected opportunity.

 After all, at the beginning of 2003, there were very few investors who were willing to accept the prediction that the iPod was a product capable of reversing Apple Computer’s seeming long slide into a niche provider of personal computers at best and an irrelevance at worst. And certainly a prediction that KMart Holdings would successfully emerge from bankruptcy, achieve an equity market capitalization of nine billion dollars, and perhaps acquire Sears Roebuck and Company would have been widely greeted with skepticism by everyone experienced enough to have heard seemingly forever some version of the KMart turnaround story and smart enough to realize the futility of the claim that this time it really is different.

This final lesson is in many ways the most difficult for someone to know when to apply; it is extremely important and yet is seldom applicable, the occasion on which it usually applies can often be recognized because it is the time at which such fundamental change seems beyond the realm of possibility and yet a careful examination sometimes reveals that the building blocks have been carefully put in place over an extended period of time and that the necessary preconditions have all been met. Every reader undoubtedly knows at least one Red Sox fan who had finally given up all their earlier hope of redemption at that dark moment when the Yankees led the series 3-0 and subsequently refused to believe that ultimate salvation was possible until the final out had been made by the Cardinals and the long awaited championship was secure. Likewise, in the few circumstances where profound corporate change has in fact occurred and a truly unique investment opportunity is available, most supposedly “smart money”, conditioned by years of experience, usually refuses to believe that it really is different this time.

While the various lessons outlined during the previous discussion may seem intuitively obvious, such a conclusion is at least partially a testament to the power of analogies to illustrate such important points so vividly. They are like the proverbial treasure “hidden in plain sight” but only recognizable after its identity has been revealed. Hopefully, the analogies drawn in this piece will serve as reminders of how easy it is to make the costly mistakes discussed. So, whenever you are tempted to invest in opportunities providing the short odds generally afforded by conventional wisdom, take time to ascertain that those widely held beliefs have almost no chance of being wrong. Contrarily, remember if you limit your risk in a reasonable way, the expected value of making the contrarian bet on a long shot is much more likely to be positive. Likewise, when even the most diehard optimists have given up and positive change seems almost outside the realm of possibility, remember that it is always worth objectively examining the evidence of the small likelihood that this might be the time when those often heard and seldom accurate words “this time is different” could be true. May the phrase RED SOX WIN! always remind you of the investment relevance of the fact that as improbable as it appeared entering the ninth inning of ALCS game four on October 17^th, only ten days later Red Sox fans everywhere were staging a long awaited victory party.

 Postscript: this material will appear in expanded form as two chapters in DIAMOND WISDOM:INVESTMENT PEARLS, a book about investing that I am currently writing and which is described at the web site for the book.

Tucker Andersen                                                                                  11/23/2004