Podcast Summary
Understanding the Active-Passive Debate in Investing: Markets cannot be perfectly efficient due to the cost of gathering information, requiring a balance between efficiency and inefficiency. Behavior gaps exist in passive investing, impacting time-weighted and investor returns, emphasizing the importance of informed and thoughtful investment decisions.
Key takeaway from this podcast episode is the importance of understanding the active-passive debate in investing and the role of information efficiency in markets. Michael Mauboussin, the head of global financial strategies at Credit Suisse, discussed his perspective on this topic, drawing from academic research and the idea that markets cannot be perfectly efficient due to the cost of gathering information. He emphasized the need for a balance between efficiency and inefficiency to motivate investors to continue participating in the markets. Another key point was the existence of behavior gaps, even in passive investing, which can lead to significant differences between time-weighted and investor returns. Overall, the conversation highlighted the importance of being informed and thoughtful in investment decision-making, regardless of whether one leans towards active or passive strategies.
Evaluating Excess Returns in Investment Industry using Economic Profit Calculation: By calculating gross returns (pre-fee minus benchmark) multiplied by Assets Under Management (AUM), we can determine the amount of value extracted from the market by fund managers.
The concept of excess returns in the investment industry can be evaluated using an economic profit calculation, similar to how company performance is assessed. This approach, suggested by Jonathan Burke and Richard Green, involves looking at gross returns (pre-fee minus benchmark) multiplied by Assets Under Management (AUM). By doing so, we can determine the amount of value extracted from the market. For instance, a fund manager with high alpha but low AUM may not be extracting significant dollars from the market despite their strong performance. Conversely, a manager with modest alpha but large AUM can extract substantial value. Over the past decade or more, the amount of available alpha has declined faster than fees, leading to a natural rebalancing phase. Regulation, market environment, technology, and the balance between informed and uninformed sellers are key drivers of this shift in the investment industry, with regulatory changes encouraging the move from individual investments to mutual funds and later to index funds, and technology enabling easier access to information and automated trading.
Technology and market conditions have transformed the investment landscape: Advancements in technology have led to more efficient data processing and analysis, while market conditions have driven investors towards low-cost index funds and ETFs, increasing competition for active managers.
The advancement of technology and the shift towards index funds and ETFs have significantly changed the investment landscape. Reflecting on the industry's evolution, technology has made it possible for us to process and analyze vast amounts of data much more efficiently than in the past. For instance, contrasting the experience of a trainee in the 1980s working with an analyst using paper spreadsheets to today's advanced spreadsheets and databases is mind-boggling. Additionally, market conditions have influenced investor behavior, with periods of weak equity market returns leading investors to seek low-cost alternatives, such as index funds. This trend has led to increased competition among active managers, making their jobs more challenging as they are now only competing against the "smart money." Despite these changes, it's important to recognize that markets are not always informationally efficient, and there may still be opportunities for active strategies to outperform, although it can be challenging to consistently do so.
Impact of Indexing and ETFs on Market Liquidity: The rise of indexing and ETFs has led to changes in market liquidity, making it harder for active managers to exploit mispricings. Fewer active managers, increased liquidity demanders, and uncertain market maker behavior could create challenges during market downturns or dislocations.
The rise of indexing and ETFs has led to higher valuations for certain stocks and asset classes, increased intra-sector correlations, and changes in market liquidity, making it more challenging for active managers to exploit mispricings. Historically, active managers acted as liquidity suppliers, but now there are fewer active managers due to industry outflows and performance pressures. Liquidity demanders, such as index fund and ETF investors, may panic sell in times of market stress, leaving a gap in market liquidity. Market makers, once provided by active traders on the floor of exchanges, are now largely filled by high-frequency trading firms, but their behavior in stressful markets is uncertain. These distortions may not be noticeable in normal markets, but they could surface and create challenges during market downturns or dislocations.
Behavioral gap between passive and active investing: On average, investors lose more money due to their own behavior than they pay in fees, with the behavioral gap reaching up to 120 basis points per annum
The difference between passive and active investing goes beyond just fees. The behavioral gap, which is the difference between time-weighted and dollar-weighted returns, can be as large as 120 basis points per annum. This means that investors, on average, are losing more money due to their own behavior than they are paying in fees. However, it's important to note that this isn't a closed system, and corporations play a role in these transactions. Companies buying back shares or issuing new stock can result in wealth transfers that aren't necessarily detrimental to one party at the expense of another. The Sloan paper "Wealth Transfers from Equity Transactions" provides evidence of this effect, which is particularly significant in environments where companies are actively repurchasing or issuing equity. In summary, while fees are an important consideration, investors should also focus on their own behavior to maximize returns.
Private Wealth Creation in US: Fewer IPOs, More M&As and PE Buyouts: The trend of fewer IPOs, more M&As and PE buyouts in US markets has led to significant wealth creation and capture in private markets, limiting access for average investors. A well-diversified portfolio should include early and late stage ventures, private equity, and public markets.
The trend of fewer companies listing their shares in the public market in the US, particularly in the last 20 years, has led to a significant amount of wealth being created and captured in private markets rather than public ones. This phenomenon, which is more pronounced in the US, is due to several factors including mergers and acquisitions (M&A), private equity buyouts, and a dearth of initial public offerings (IPOs). The result is that access to these opportunities is limited for the average investor, making it important for a well-diversified portfolio to include early stage venture, late stage venture, private equity buyouts, and public markets. Additionally, regulatory changes have facilitated this trend, allowing companies to stay private for longer periods of time, resulting in substantial economic rents being captured before the companies even go public.
The Significant Value Shift from Public to Private Markets: The private market sector, represented by unicorns, holds a significant amount of value, making public market analysis more complex and increasing wealth inequality.
The private market sector, represented by unicorns, now holds a significant amount of value, estimated to be around $5-600 billion. This has made the public market scene more complex, as there are fewer things for analysts to focus on and the value gap between private and public markets is growing. The number of Chartered Financial Analysts (CFAs) has increased dramatically over the years, making it harder for public market analysts to distinguish themselves. The private equity gap, or the portion of returns being captured by these private companies, is a large and intriguing question. The wealth inequality implications of this trend are significant, with a few billionaires holding a substantial portion of this value. Some argue that more companies should go public to increase transparency and accountability, but the costs, such as Sarbanes Oxley compliance and quarterly reporting, have increased. A cost-benefit analysis suggests that companies are staying private due to these increased costs, but initiatives from regulatory bodies may encourage more public listings.
Late-stage liquidity landscape changing with backdoor IPOs and pre-IPO investments: The current market landscape for late-stage liquidity is evolving, with some companies offering employees backdoor liquidity and mutual funds investing in pre-IPOs. However, the lack of transparency and varying investment valuations raise concerns about potential overvaluation and sustainability.
The current market landscape for liquidity, particularly in late-stage venture and private equity, is undergoing significant changes. Some companies are providing backdoor liquidity to employees through large funding rounds, while mutual fund companies are increasingly investing in late-stage venture as part of the "pre-IPO boom." However, this "Wild West" environment lacks transparency, with investors marking their investments at different prices. Bill Gurley's concerns about the lack of liquidity and the potential overvaluation of companies resonate, as the high IRRs for venture capital firms may not be sustainable. The private equity industry, with its high fees, is experiencing growth but may face challenges as market forces test the valuations of these companies. The potential for mainstream investors to access earlier parts of the market at cheaper prices could be an interesting development to watch.
Understanding the trade-off between control and liquidity in private equity: Private equity offers investors extended time horizons and greater control, but at the cost of reduced liquidity. Investors must consider this trade-off when evaluating private equity opportunities alongside other investment classes.
Private equity firms, like the European buyout fund discussed in The Wall Street Journal, can offer investors extended time horizons and greater control over their investments, but this often comes at the cost of reduced liquidity. This trade-off between control and liquidity is important for investors to understand, as it applies not only to private equity but also to other investment classes like public markets and endowments. The private equity industry's ability to control assets and respond to challenges makes it an attractive investment option for some, but individual investors must weigh the desire for liquidity against the potential benefits of longer-term control. The base rate book and the updated paper on moats mentioned in the conversation offer valuable tools for analyzing companies and investment opportunities, helping investors make informed decisions while navigating the complexities of the investment landscape.
Considering Inside and Outside Views for Accurate Analysis: Effective analysis requires combining your own research and biases (inside view) with historical trends and data (outside view) for accurate forecasts and a better understanding of concepts.
Effective analysis involves both an "inside view" and an "outside view," or your own research and experience, as well as considering historical trends and base rates. The inside view is a common approach where you gather information, build a model, and project into the future based on your own research and biases. However, the outside view, or base rate, involves setting aside your model and looking at historical trends and data to understand what has happened in similar situations before. This can be a difficult way to think because it requires letting go of cherished information and finding relevant base rates. However, combining the inside and outside views leads to more accurate forecasts and a better understanding of concepts like regression toward the mean. For example, when analyzing a company's growth rate, using only the inside view might lead to overly optimistic projections, while the outside view can provide a more realistic perspective on what growth rates are historically achievable.
Combining quantitative data analysis with domain expertise: Using extensive resources to analyze various measures of corporate performance and considering both inside (domain expertise) and outside (big data analytics) perspectives can lead to more accurate and informed business modeling.
Combining quantitative data analysis with domain expertise can lead to more accurate and informed business modeling. The speaker discussed his experience on the buy side, where he lacked access to necessary data despite having valuable ideas. Upon rejoining Credit Suisse, he and his team used extensive resources to analyze various measures of corporate performance, such as sales growth, operating margins, and return on capital. This data-driven approach allowed them to understand regression rates and create base rates for various business models. The speaker also emphasized the importance of considering both inside (domain expertise) and outside (big data analytics) perspectives when modeling businesses. He introduced the concept of "man plus machine" or "inside plus outside," suggesting that the combination of these two approaches can lead to better results than relying on one alone. The speaker also introduced the concept of shrinkage factor, which determines the extent to which past performance is factored into future forecasts. By using statistics and simple correlations, it's possible to plot shrinkage factors for various things and gain a better understanding of how much weight to give past performance when making forecasts.
Understanding Regression Towards the Mean: Regression towards the mean is a mathematical principle that indicates if the correlation between two measurements is less than 1.0, there will be a regression towards the average. This concept can help investors make informed decisions in uncertain markets, especially in industries with varying rates of regression.
While individual company returns, such as those of the firms discussed, can be persistently good, predicting future market performance, like the S&P 500, is largely a matter of chance. The correlation between year-over-year stock market performance is zero, meaning there is no reliable information from one year to the next. However, understanding the concept of regression towards the mean can help inform investment decisions. This mathematical principle, which applies to almost everything, indicates that if the correlation between two measurements is less than 1.0, there will be a regression towards the mean. The rate at which this occurs can vary depending on the industry or economic driver. For instance, consumer staples companies tend to regress more slowly than industries with greater competition. By acknowledging and understanding these economic principles, investors can make more informed decisions, even in the face of uncertainty. This knowledge can help active managers navigate the markets and make the most of opportunities.
Comparing market expectations to a company's fundamental performance: To make profitable investments, investors need to identify the gap between market expectations and a company's actual performance. Building a base rate and analyzing strategic and financial data can help identify potential mismatches and opportunities.
Identifying the gap between market expectations and a company's fundamental performance is crucial for making profitable investments. Building a base rate, or a baseline expectation, is an essential step in this process. By comparing this expectation to a company's strategic and financial analysis, investors can identify potential mismatches and opportunities. Additionally, market efficiency varies around the world, and less efficient markets may offer more opportunities for mispricings. Examples of non-fundamental reasons for buying or selling include spin-offs and the leverage cycle. These situations can create opportunities for investors who are thoughtful about their analysis and have a clear understanding of why they believe there is an expectations gap.
Rules and structures in organizations create opportunities for distressed or opportunistic investing: Understanding the rules and structures of organizations can lead to forced transactions, creating potential edges for nimble, cost-effective investors. These opportunities add up over time and contribute to a sustainable source of value creation, or a moat.
Understanding the rules and structures that govern trading activities in organizations like Vanguard or index funds can present opportunities for distressed or opportunistic investing. These rules can lead to forced transactions due to rebalancing or other factors, creating potential edges for investors who are nimble, cost-effective, and have a deep understanding of these rules. The financial crisis serves as an example of this, where some investors made significant gains by providing liquidity to sellers who had no choice but to sell due to margin calls. While these opportunities may seem small, they can add up over time and provide a sustainable source of value creation, which is the essence of a moat. Moats, as popularized by Buffett, refer to the ability of a company to create and sustain value over time through competitive advantages. Understanding the components of moats and how to build and maintain them is crucial not only for investors but also for entrepreneurs and business owners. The paper discussed in the conversation provides valuable insights into this topic and is highly recommended for further reading.
Understanding the balance between steady state value and future value creation: Investors pay for a third of a company's steady state value and a third of its future value creation. Analysts can evaluate a company's worth by examining industry trends and firm-specific advantages to determine sustainable returns on capital.
The value of a business can be broken down into two parts: steady state value and future value creation. The steady state value is what a company would be worth if it earned its current earnings forever. The future value creation is the value of investments the company makes that will create value in the future. According to the Miller Modigliani theorem, investors on average pay for every dollar they invest, a third for steady state value and a third for future value creation. To quantify this, analysts can follow a three-step process: getting the lay of the land, specifically looking at the industry, and looking at the firm-specific advantage. By understanding where a company's return on capital comes from and whether it is sustainably high or low, analysts can make informed investment decisions. Tools such as industry maps and profit pool analysis can help in this process. Overall, understanding the balance between steady state value and future value creation is crucial for evaluating a company's worth.
Analyzing industry competition with Porter's 5 Forces and value chain analysis: Understanding industry competition requires examining market forces, company strategies, and disruptive innovation. Porter's 5 Forces and value chain analysis provide valuable frameworks for this analysis, helping to inform strategic decisions.
Understanding the competitive landscape of an industry involves asking the right questions, analyzing market share trends, and identifying trade-offs that companies make for their competitive positions. This process includes examining industry forces using Michael Porter's 5 Forces and value chain analysis, as well as considering disruptive innovation. By doing this thorough analysis, an analyst gains valuable context to interpret data and make informed decisions. Additionally, it's important to remember that strategy is about trade-offs, and companies make these decisions based on differentiation or low cost production. Although it may take time and effort, this foundational work allows for a deeper understanding of the industry and the companies within it.
Understanding business moats and valuation: Investing involves buying good businesses at low prices. Understanding a business's competitive advantage and valuation are crucial for success. Greenblatt's magic formula is a simple approach, but a multifactor analysis considering sector-specific ROIC persistence and trade-offs between competitive position and returns can provide more insight.
Understanding the competitive advantage of a business and its valuation are two crucial aspects of investing. While the market recognizes this relationship, there's room for improvement in quantifying the moat beyond just numbers. Greenblatt's magic formula, which combines Return on Invested Capital (ROIC) and EBITDA to EV, is a simple approximation of this idea. However, a more nuanced, multifactor approach could provide even more insight. For instance, the persistence of ROIC or ROE varies across sectors, and considering this factor can help in identifying undervalued businesses. The trade-off between competitive position and returns is a conscious decision that companies make. For example, a bank that offered longer hours at the cost of lower returns on CDs and checking accounts created immense value for its customers. In the asset management industry, applying these principles could involve assessing the moat and valuation of various funds and identifying those that offer attractive returns for the risk taken. Overall, the goal is to buy good businesses at low prices, and understanding the competitive landscape and valuation are essential components of this strategy.
Factors influencing asset management success: Industry conditions matter, but unique firm strengths and preparedness for liquidity opportunities in alternative assets and unexplored markets can lead to success.
Both industry and company-specific factors play a significant role in the success or failure of asset management firms. While industry conditions are important, the unique strengths and expertise of individual firms can help them stand out and thrive. In the context of the current market landscape, opportunities exist for those prepared to provide liquidity, particularly in the alternative asset class. Additionally, exploring less efficient markets outside the US, such as parts of Asia, Europe, and Africa, may present unique opportunities for investors. Ultimately, the world of asset management is vast, and there are pockets of opportunity in various corners, requiring continuous exploration and adaptation.
Strategies for maturing or declining industries: Effective strategies for maturing or declining industries include product refinement, investment in service quality, process innovation, niche strategy, divestment strategy, and harvest strategy. The harvest strategy involves recognizing a business may not grow much and returning cash to shareholders instead of continuous reinvestment.
In the world of business and investing, understanding industry structures and the strategies that can be employed in mature or declining industries is crucial. For instance, in the asset management industry, which can be categorized as mature or declining depending on perspective, strategies like product refinement, investment in service quality, process innovation, niche strategy, divestment strategy, and harvest strategy can be effective. The harvest strategy, in particular, means recognizing that a business may not grow much or at all and returning cash to shareholders instead of continuously reinvesting. This can be seen as a way of giving back to the capital markets, which may be able to redeploy the funds more effectively than the company itself. This was discussed in relation to Buffett's decision regarding IBM. Additionally, the speaker recommended several books that have recently peaked their interest, including "Deep Work" by Cal Newport and "The End of Theory" by Rick Bookstager, which offer insights into gaining a competitive advantage in a cognitive world and understanding the complexities of economic and financial theories, respectively.
Understanding Man and Machine: Insights from a Chess Grandmaster: Stay curious and adaptive as technology advances, understanding the strengths and weaknesses of both humans and AI, and their potential to complement each other.
Technology, specifically artificial intelligence (AI), continues to evolve and challenge the way we think about intelligence and human capabilities. This was highlighted in a recent conversation on the Invest Like the Best podcast with Patrick O'Shaughnessy, where they discussed Garry Kasparov's book "Deep Thinking." Kasparov, a renowned chess grandmaster, shares his insights from his historic match against IBM's Deep Blue in 1997 and the advancements in AI since then. The conversation emphasized the importance of understanding the strengths and weaknesses of both man and machine, and how they can complement each other. The podcast also underscored the value of continuous learning and exploration, whether it's through reading books or engaging in thought-provoking conversations. Overall, the discussion underscores the importance of staying curious and adaptive in the face of technological advancements.
