China -- Part B: Things Our Man ponders that make him skeptical

- Consumer Spending:
The most common argument Our Man hears is a version of “don’t worry about it, China’s domestic consumption is low, and due to the formation of a middle class it’s going to increase so there’ll be loads of domestic demand”. Part of that argument is certainly true, at not even 33% of GDP Chinese consumption is low…very low, and in dollar terms (c$1.25trn) we’re talking about all of those Chinese consumer spending as much as British consumers! However, blithely assuming it’s going to go up (because you want it to) isn’t much of an answer, and Our Man has two major issues:

1). Chinese consumption has declined steadily since the 1980’s when it was consistently in the 50-54% of GDP range. Why should it suddenly rise? I’ve not yet heard anyone say that the Chinese just enjoy saving, more than the rest of us, so we can safely rule that out…though the arguments that they save because of the lack of welfare/social safety net and because investment “crowds it out” have merit. However, the underlying reasons why are important. Of the arguments, I think it’s certainly fair to say that a major reason that investment crowds out consumption is because government policy favors investment; through low interest rates, distorting the way in which credit is allocated (the benefits of being able to tell the banks who to lend to, and how much) and having no great penalty for misallocated investment (the benefits of being State-Owned Enterprises, and not having to survive a capitalist system). It’s pretty clear to Our Man that to change these things, and thus really encourage consumption, we’re not talking about the Chinese making small changes to their financial system but also to the growth engine that’s served them so well recently (and got the bulls so excited). That kind of change doesn’t come quickly and perfectly smoothly!

2). It’s the maths, stupid! For all Wall Street’s preoccupation with modeling and spreadsheets, numbers are tossed around with too little thought. For example, Our Man was having this discussion with a sell-side friend “Consumption fell from 50% in 1990, all I’m saying is that it gets back to 50%. That’s the same as most Asian countries (e.g. Korea, Malaysia, etc) and well less than Europe (c65%) and the US (c70$)”. On the surface it sounds like he has a reasonable point, but does he? Not particularly. For consumer spending to return to 50% of GDP by 2030 (fully 20 years away) would require consumer spending growth to outpace total Chinese GDP growth by 2-2.5% per annum and GDP (ex-Cons Spen) growth by 4-5% each year. How likely is that? Well, bear in mind that the bulls won't consider the quickest option for an increase in consumer spending as % GDP, namely that China's GDP growth rate slows dramatically (or goes negative). Thus we're left with a situation that immediately calls for both China to grow quickly & consumer spending growth to surge, despite the issues mentioned above...and that's not even considering the impact that things to aid consumer spending (like wage increases, or people moving to the cities but then garnering their wage from production of tradable/exportable goods, etc) may have on the rest of the economy. Maybe the Chinese government are just better at managing an economy, and transitioning it from one driver to another, than the rest of the world but that's a lot of faith to base an investment case on.

- Banking Sector & Credit
As mentioned above, one of the advantages the Chinese government has is that they can dictate the amount of bank lending. Like much of the Chinese model, this also subtly implies that the primary driver for financial enterprises (including those private ones) is not entirely profit-focused. Thus Our Man doesn't think it is a massive leap to suggest that if banks are extending credit because they are ordered to there's a decent probability that they're more likely to have more bad loans than if they were driven by considering whether these loans would be profitable. Furthermore, looking historically, the biggest guide to potential bubbles has been the presence of easy credit and while China's lending target of 7trn yuan for 2010 is a decrease from the exceptionally lax 10trn yuan in 2009, it represents a significant increase over any prior year (e.g. 4.9trn yuan in 2008). Additionally, China's been through a non-performing loan crisis before (c10yrs ago)...and the government's response was a glorified version of extend & pretend (in short: govt sponsored AMC's bought the debt, and issued the banks bonds paying 100% and 50% of face value of the debt. The problem being the debt isn't worth 50-100% of face value. So far, as the debt has been liquidated the interest on the bonds has been paid, allowing the banks to treat them as whole, but when the first bond came due in December it was rolled, as the AMC can't pay the principal(!), with a letter of support from the Ministry of Finance.).

- Investment and Resource Allocation
The skepticism Our Man has here is a continuation of those listed above; a significant number of the recipients of the banks' (government ordered) credit are government sponsored/owned entities (again with no focus on profitability). Thus you have creditors (with no focus on profit) lending to borrowers (with no focus on profit) -- a recipe for misallocation of resources and non-performing loans.
Why does this matter? Historically, as noted in part A, China benefited from its investment in capacity by increasing its share of global exports. Now however, China already punches well above its weight in the export markets (it represents a greater percentage of global exports, c15%, than it does global GDP, c8%), but it continues to focus on building yet more capacity with the aim of increasing its exports (irrespective of the marginal returns on such investments in capacity). A recent public research piece from Pivot Capital (here) talks a lot about the fixed capital formation in China, both how it's broadly unprecedented and how it drove a significant portion of 2009's growth.

- Global Trade & Mercantilist Model
It's often said that pictures are worth a 1,000 words, hence Our Man will attempt to curtail his loquaciousness by showing you his favourite Financial picture (from Charles Kindleberger's book "World in Depression") showing what happened to Global Trade during the Great Depression.

Now, take into account the recent rumblings about protectionism and imposition of tariffs on Steel, Tires and Chicken (!), and consider what the impact on China would be if global trade did anything even mildly similar today. Our Man suspects that it's not going to be good for the world's largest exporter, who already has an oversized slice of the pie and is building (potentially rampant) over-capacity.

As an aside, it seems slightly bizarre to Our Man that China seems intent to proceed (at a vastly faster rate) down a similar mercantilist model to Korea & Japan before it, by seeking to become the supplier to the world and generate current account surpluses as a tool/proxy for national power. (In much the same way, as it seems odd to Our Man that the US Fed/Treasury seems keen to mimic Japan's policies of the 90's, in the hope that by doing so in greater size will bring about a different result).

- Reserves and Current Account Surpluses
A recent argument that Our Man encountered is that one should never bet against a country with substantial reserves. This argument is muppetry, at it's finest! Firstly, Our Man has no idea what reserves have to do with anything (with regards to the investment positions mentioned in part C), especially as reserves are a result of the imbalances (i.e. those big current account surpluses over time, from being an exporter) that have helped caused some of the issues. Secondly, even if reserves had anything do with anything, then Our Man would point out that China's reserves are 5-6% of global GDP and the only 2 other times that a single country has had anything similar as a % of Global GDP are.......late 1920's USA and late 1980's Japan! While this doesn't mean that China is guaranteed to face the same market crashes that Japan or the US did at that time, it certainly should debunk the counter-argument that one should never bet against a country with substantial reserves!

- Urbanisation
Another argument that Our Man has heard is that the migration of people from rural areas to the city's justifies the continued increase of real estate (both residential and commercial) in Chinese cities. Our Man has two observations on this; 1). It presumes that the migrant worker can afford the housing being built (which emprically seems somewhat questionable) and 2). building in anticipation of migration of people, by itself, is a weak argument as trends can quickly reverse (or stagnate) causing massive oversupply -- you'd think that the examples of Spain and Florida in the last 3 years would make this palpably obvious, but apparently not.

- Demographics
Look at the 2 pyramids below; China's population in 2010 and 2030 -- what should become immediately apparent is that China's going have a lot more older people (60+) in 20 years time and a lot less young adults (20-35yrs). In numeric form, in 2030: 31.8% of the adults will be 60+ (vs. 17.8% today), only 21.1% will be 20-35yrs old (vs. 32.3% today) AND the adult population will decline by c10%.
That's the result of China's 1-child policy! The impacts of those changes are significant, since it's the 20-35yo cohort that add the most to GDP (think buying first car/house/etc) and one of China's apparent advantages is endless supply of labour. Instead Our Man fears that China will get old before it gets rich.

- Stimulus & Data
The Chinese stimulus in 2009/10 at $1trillion was far larger than the US stimulus, especially when considered as a % of GDP (China's stimulus was 25% of GDP!). Given the impact this had on GDP, it should be no surprise that China showed great growth last year! However, just like the US, the impact of stimulus turns from a positive to a negative on GDP growth rates unless the stimulus is continued/renewed OR private demand steps up to replace it. Separately, there seems to be much teeth-gnashing over the quality of US data (e.g. the BLS revisions on Friday to the payrolls numbers for 2009) yet no such qualms exist over China (despite very strange data, like auto sales up 80% through October...yet gas sales up only 8%).

Next Up: The warning signs Our Man is watching, and trade ideas

Portfolio Update: Baling Out and Going (Almost) All In

Baling Out
THRX: The eagle-eyed amongst you will have noticed that it fell through Our Man's mental "stop loss" for the portion viewed as tactical.  Despite some delays in getting the requisite approvals, Our Man sold just over 50% of the position.  The owl-eyed amongst you, will notice that Our Man disposed of some of the strategic piece of the position too. This is a result of Our Man's increased bearishness, with the market (S&P) falling through a number of key technical levels in the recent week or so.  The hope is that by under sizing the position now, Our Man will (at some point in the undetermined future) for taking the ‘opportunity cost’ risk and have both the available firepower and mental clarity to be able to top up his strategic position at a significantly more attractive price. 

GLD: Our Man's Long position in Gold has long been the one that has been causing him the most intellectual discomfort.  Today, the skeptic in him finally won out and the entire Gold position was closed.  While Our Man is certainly sympathetic to the bullish arguments on Gold (in particular it's hedge against bad governance by the US Govt/Fed/Treasury, and as protection against a emerging-market type 'sudden stop' occurring in the US Dollar), the two primary bearish thoughts in his mind won out.  Firstly, while the Fed/Treasury/US Govt have done little to show they can be trusted to not debase the dollar, currencies are a relative value instrument and the dollar is (in the short-medium term) the least worst of the major liquid currencies (the Euro, Yen and Sterling all have far more immediate risks in terms of budget deficits, bailouts, etc).  Over the past 12months, based on Kitco's calculation, about 1/2 of Gold's return came as a result of weakening in the USD and about half from increased buying or 'fundamentals'.  While this was important to Our Man's thinking, the second more philosophical point was of greater importance.  Leaving aside those bulls that seem to believe that Gold will go up whatever the circumstance, over the last 6-12months there has been a general groundswell of opinion that Gold is a "flight to quality" safe haven.  As this clamour has grown, Our Man has steadily become more skeptical of it -- can an instrument that's both viewed as a "flight to quality" (i.e. uber-low risk) safe haven AND bought by people as such PRIOR to the flight to quality, actually be a flight to quality instrument??  After much pondering, Our Man has decided the answer's probably not...that being out of favour, prior to the flight to quality, is probably a prerequisite for the instrument to actually behave like a safe haven during the flight to quality scenario.

Going (Almost) All In
HSTRX: Our Man added (or at least has tried to; he’s still waiting for the transaction to take place) a new position to the portfolio, in the Hussman Strategic Total Return Fund, though its theme is broadly consistent (a majority in Treasuries, though the ability to buy equities too) with Our Man's outlook.  Given the constraints on Our Man (along with his lack of substantial fixed income experience and access to bonds), outsourcing the ability to choose between bonds seems sensible.  Our Man has been fortunate enough to read Dr. Hussman's weekly market comments & thoughts over the last 5-years or so; while not always in total agreement with Dr. Hussman (such as currently on the probability of inflation), Our Man always finds him thought provoking and would heartily recommend his commentary.

With these changes to the portfolio, the tilt has become noticeably bearish with the majority of assets (combining the direct and indirect exposures) held in Treasuries, continuing to reflect Our Man's view both that they will be a flight to quality instrument and that (while lending remains constrained) the inflation prospects are much more limited than the market appreciates.  Coupled with this the fund has a net Short position in equities (expressed through puts on the S&P and GS), which will only expand further should markets decline by 10-15%.  While the use of puts constrains the capital loss in the equity positions (to c200bips), it should be expected that the portfolio will suffer from a return to risk-seeking behaviour in the markets.

Why Almost? 
Our Man has a few other put positions he's pondering about, most notably in Mining & Australia (see upcoming China series) as well as potentially in REITS (especially Hotel REITs).  However, he'd have to both find appropriate instruments and see a far more serious technical breakdown in the markets before considering putting these positions on.

Portfolio (as of cob 2/5)
56.98% Long Bonds

42.46%: L Long-end Treasuries (22.3% in the Aug-29 Bond, and 20.2% in TLT)
14.52%: L Bond-orientated Funds (7.7% in VBIIX and c6.79% in HSTRX, when its completed)

2.03% Short Equities (on a delta-adjusted basis)

2.33%: L THRX
4.51%: L Restricted Equities

-5.89%: S S&P (via SPY puts, with a Dec-10 expiry and strike prices of 100 and 85; 76bips and 34bips of premium at risk, respectively)
-2.98%: S GS (via a put, with a Dec-10 expiration and a 120 strike; 81bips of premium at risk)

China Thoughts: Part A

Our Man has, over the last few months, alluded to his deep skepticism surrounding the broad positive conventional wisdom around China but has been spectacularly inept at providing further details as to why he feels this way.  With other skeptical mutterings (most notably from Jim Chanos) becoming more common place, what better time to finally jot down some thoughts.

A Short Recap:
To start off with, it might help to recap some of the things that have helped China do so well?
- Joining the WTO:  If Our Man had to point to the thing that had the largest impact, it's this; by doing so (in 2003) China essentially ensured that there was a market for it to take advantage of its low costs. 

- Low cost:  The big one that's focused a lot upon is labour; wage costs started from a low base and wage growth in China was pretty stagnant from the mid-90's to 2005, with the pool of labor swelled by those no longer needed in agriculture (due to greater efficiency).  However, China also benefited from the other costs being low, with rent/land and raw materials being obvious examples.

- Low base:  It helps to start at a low base, in both nominal dollar terms and on a GDP/capita basis (China's nominal GDP, in $-terms, doubled from $0.8trn to $1.6trnbetween 1995 and 2003.  It has more than doubled since, to over $4trn)

- Reform: There is little doubt that China is today more ‘Westernized’ (both in terms of society and having some form of capitalist approach) and has greater freedoms than it was 5-10years ago. 

- Good planning: There can be little argument that the Chinese government managed the economy well, building infrastructure ahead of growth and making good policy decisions (see joining WTO).

- Luck:  The big customer for China was the US consumer, thus China was an indirect beneficiary of both the existence and the time of the credit bubble in the US.

The problem is that these factors aren’t ones necessarily present going forwards; China’s already the largest exporter in the world (its share of world exports is around twice its share of world GDP!) and with the recent rises (in wages, raw materials, etc) it’s no longer particularly low cost (compared to SE Asia).  Furthermore, as the new US President is finding out, the first steps in “reform” are always the easiest as those with the power have more to lose the further reform goes (and if you happen to be a centrally-planned country, that’s doubly the case).

Thus the key drivers to China’s future growth are likely to be different from those that drove growth in the past; increased efficiency (to improve productivity, retain a cost advantage and move into producing higher value-added products/services) and creating new markets (especially a domestic one).

Next Up: Why Our Man is so skeptical.

January Review

Performance Review
While December was Our Man’s most disappointing month as the investor (with Mrs. OM) in the portfolio, January was Our Man’s most disappointing month as a portfolio manager despite the portfolio producing a modest gain of +0.45%. 

Why disappointing? 
The reasoning is simple; as you’ll no doubt remember, Our Man has regularly expressed his negative sentiment towards equities and this is reflected in the portfolio’s setup.  As such, we would expect the portfolio to have non-descript performance should the market’s rise but to be profitable should they stumble.  So it proved, with the portfolio up over 1% going into the final day of the month, before seeing its month’s return largely wiped away by a 100bip+ loss from the THRX position.

THRX; What happened?
 Let’s first talk (very briefly) about why THRX (a biotech company) fell; the company had applied (for the drug telavancin, to be used in nosocomial pneumonia) to the FDA to request that they be allowed to pool survival data from 2 studies.  They unexpectedly received a response from the FDA, saying that even if the FDA accepted the pooled data, the existing studies would equate to only 1 appropriate trial.  As such, THRX would need to conduct a second trial meaning a delay of at least 2-years (before the drug could be approved) and much additional cost.  Obviously, for a drug development/biotech company, this is pretty bad news.  The stock suffered heavily both from the fundamental impact (estimated at $1-1.50 per share by analysts) and especially from the change in sentiment (e.g. investors could reasonably conclude that THRX has higher execution risk than they had previously considered) that this type of news engenders.  Fortunately, while Telavancin is a very important drug to THRX (and the only one in it has in Phase III Trials, currently) they have more important drugs coming through the pipeline (most notably Horizon, in Phase II Trials).

THRX; why this was bad portfolio management?
Let us go back to what Our Man wrote, when he was delighted to inherit the THRX position -- “The sizing is a little large (6.5% of total assets, estimated), but OM is comfortable with the downside given the heavy equity put-hedge that he intends to apply”.  The sad truth is that the sizing was too large, with Our Man’s over-focus on the potential return meaning that he was reluctant to sell some immediately in order to bring the position down to an appropriate size (3.25-4.00%) given the risks involved.  This over-sizing directly resulted in an extra 50-60bips of the negative impact to the portfolio in January.

As Our Man has been discussing portfolio management recently, it seems to be a good time to highlight the secondary (and potentially tertiary) impacts of the initial error.  The side effect of it is that it leads to numerous different decision paths, which are all defensive in nature and fraught with various behavioural biases that can help compound the initial error.  A small sample of possible questions Our Man now has to deal with; should the position be reduced immediately?  Should the entire position be held, given the seeming over-reaction, and partially disposed of later?  How much should be sold down?  How much later – how much more pain should Our Man risk the position inflicting?  

By contrast if Our Man had thought more thoroughly about the risk beforehand and right-sized the position, the decision-making process now would be far easier and likely more productive.  In essence, it would boil down to is now the right time to add, and if so, to the initial level of risk (3.5-4.0%) or should the position now be oversized?
For what it’s worth, Our Man has decided to retain the full THRX position for the moment, given the severe reaction.  However, it would be better to view the existing position as two; a long-term investment position (3.5-4.0%) and a short-term tactical position (1.5%-2%).  The tactical position has a ‘stop loss’ at a strike price of $10 linked to it, with a rolling ‘take profit’ at $12.50.


Given all of the above, the breakdown of performance should be unsurprising; the stand-out contributors being the Long Treasuries positions (100bips+) and the long Put positions (25bips+), with their good work largely undone by the Long THRX position (-100bips+).

Portfolio
42.14% -- Long Long-term Treasuries (via L TLT and L Aug-29 Treasury Bond)
8.77% -- Long GLD
7.61% -- Long Intermediate Bond Fund (via L VBIIX)
5.39% -- Long THRX
4.61% -- Long Restricted equity positions (via L NWS, L CMTL, L CRDN, L SOAP)

(4.53%) – Delta-Adjusted Short position in the SPY (via L Dec-10 puts, with strikes at 100 & 85; 1.02% premium at risk)
(3.18%) – Delta-Adjusted Short position in GS (via L Dec-10 puts, strike 120; 0.85% premium at risk)

29.59% -- Cash

Thoughts on Portfolio Management -- Part B: Our Man's Risk Tenets

While Our Man has been involved in finance since leaving University, he took a non-normal route (i.e. has never spent a day inside an investment bank) to his role at a hedge fund.  While there’s undoubtedly a cost to this, there are also advantages especially when it comes to thinking about investing, considering risk and portfolio.

As such, over the years, Our Man has jotted down some risk tenets to help himself consider exposure and risk.

1. There are no 20 standard deviation events
They don’t exist.  Full stop!  The mere fact they seem to happen so frequently (the 87’crash, 94’ LTCM, 98 Asian Crisis, 00-02 Tech bubble bursting & 08-09 Great Recession to name the major ones in the last 25years) means they can’t be 20-standard deviation events!  It’s funny how they only impact people negatively -- Our Man never heard anyone explain their profits as not coming from their skill, talent, or general awesomeness but from a 20-standard deviation event.  The people who believe they are fall into one of the following categories: i). Have not thought about risk, ii). Didn’t understand the risk in their book, or iii). Believe that people are rational and market returns are normally distributed.  Our Man reserves most of his scorn and sarcastic eye-rolling for the last group; neither of the beliefs is true, have ever been true or will ever be true (while humans make decisions!)

2. Cut your losses
It’s an underappreciated fact, that making money over the long-run is primarily a function of avoiding huge losses rather than finding great winners.  That’s the magic of compounding.  Our Man thinks about this rule a lot when sizing positions – specifically, how much pain is he willing to suffer in any position and what positions are related/correlated to it -- to try and right-size the position so that the behavioural biases (especially in dealing with losing positions) that come naturally are more limited.

3. Don’t try to turn a bad trade into an investment
Speaking of behavioural biases, here’s a prime example of anchoring (to cost-price) at play – if only I hold X for a little longer, it’ll be profitable.  Sadly, Our Man has learned from experience, it probably won’t…cut your loss.

4. If you buy a stock for a reason that’s no longer valid; sell it
Our Man has struggled with this in the past, after all who likes admitting they were wrong!  Writing down why you’re investing in something, BEFORE you invest makes it an easier mistake to avoid.  Hence this blog!

5. No matter how much you know about a stock, it owes you nothing
Take emotion out of the decision making process.

6. The best hedge is to sell
It really is; at best when hedging/pairing you’re not removing risk but just swapping directional risk for basis risk.

7. Never attempt to use leverage to turn a mediocre return into an attractive one
The dirty truth is that leverage introduces far more risk, than the return it helps to generate.  The most basic is that while returns increase linearly, risk increases at a rate that is closer to exponential.  Furthermore, new risks such as additional risks (e.g.  counterparty risk – you know that your leverage provider will pull the leverage at the worst possible time) are introduced.

8. Avoid incremental thinking; be decisive
The more performance hurts, the easier it is to say “things will bounce back” or to nibble around the edges and not make a change.

9. Don’t be afraid to have no positions
Sometimes (like now in Our Man’s perspective) things just aren’t that attractive on an absolute basis; better have no positions and suffer the opportunity cost of that (i.e. risk under performance) than to have positions you don’t particularly want and suffer the (possible) negative returns impact of that!

10. Don’t fight the tape; respect the markets
Our Man’s view is that the simple act of taking a position is an intellectually arrogant thing to do (see below, re. Our Man’s position in Treasuries), and that Keynes is right (“markets can remain irrational far longer than I can remain solvent”), thus this rule tries to help with timing.  In essence don’t become insolvent before you have a chance to be right!

Our Man’s Long-end Treasury position implies that he thinks not only are the many smart people who’re talking about shorting Treasuries wrong, but so is the entire market for pricing them so attractively!  I think we’d all agree that it’s a pretty intellectually arrogant stand point!

11. Watch for “Salzmans”; sophisticated ways to lose money
The most important skill in Wall Street isn’t being able to think, it’s being able to sell!  As such, investors have to be watchful for products that fill a need in the market and thus seem interesting and useful, but instead are just sophisticated ways of losing money.  Simple examples are Commodity ETFs (e.g. UNG & USO; where the contango/backwardation impacts in those markets mean that price performance bears no resemblance to that of the underlying commodity) and Short ETFs (where the compounding impact kills the performance, such that over longer time periods it bears on reflection to the underlying).

12. Are you Short a put? Are you really being paid enough to be Short that put?
A Short put position has the classic large left-tail that (inevitably) eventually results in a blow-up; while the return stream looks steady and predictable (i.e. collecting premium) an sharp market move (which the seller of the put often calls “a 20-standard deviation” event) results in a substantial loss of capital.  Short-put positions often offer a mediocre return, and are thus leveraged up, resulting in impressive blow-ups. 

13. The object of these tenets is not to be conservative; it’s to make the right decision
Our Man likes this little tenet.  It serves as a good reminder that while he  (like most) has a tendency to chase trends and hopes for very profitable years, that these tenets aren’t designed to encourage him to reduce to be more conservative.  Instead, the serve to help him make the right decisions which hopefully means that he sacrifices opportunity cost in order to avoid the big down years that can ruin performance.

14. See number 1; there are no 20-standard deviation events
Since, it’s so much easier to blame bad fortune for our own failures.

Thoughts on Portfolio Management – Part A

One of the things that Our Man has noticed from his years in and around the hedge fund industry is that ability to manage a portfolio and think about the risks embedded within it is one of the most undervalued skill sets in the industry. 

Thus, in a bid to help himself become a better portfolio manager, Our Man’s going to be jotting down some of his thoughts and observations over the coming months (perhaps years, who knows!).  The categorizations aren’t mutually exclusive, and given his Swiss Cheese of a brain it’s likely Our Man will forget things so don’t be surprised to find addendum’s to them as we wander down this path.


The Analyst-Portfolio Manager Gap
Given his non-traditional background, coupled with being an analyst in his day-job, and a PM in this night-job, Our Man ponders a lot on this subject.  In fairness, a primary portion of this divide stems from Our Man’s puritanical belief as to what a PM’s role; namely that it’s predominantly focused on understand and managing the risk in the portfolio, with the intent of generating an absolute return.  Clearly there are other definitions of the role (e.g. maximizing annual returns, beat a bench-mark, etc), which may lead others to not see such a gap.

Furthermore, portfolio management is also something on which there’s very little formal training; after all the path is generally start as an analyst, become a very good analyst, then eventually get portfolios to manage – but are the skills to be an analyst and to be a portfolio manager the same?  Our Man believes that while there’s certainly overlap, there are substantial differences; most notably, that an analyst can generally start by considering each position of his/hers in the portfolio as unique, whereas as a PM must consider all positions are being inter-related.  These are two very different starting points, which require very different mindsets and skills.

Yeah, but what does that all mean?
At an exceptionally simplified level good analyst’s job is to identify the key drivers (1-3, normally) behind a company’s performance, to do a lot of (often very dull) follow-up research to identify various potential paths of these drivers and the probabilities of these paths, and then model out the expected returns of these potential paths.   In reality of course, neither the potential paths nor the expected returns from them are simple discrete numbers but ever-changing. 

However, for the point of a simple illustration, let’s assume our analyst is infallible (i.e. the probabilities and expected returns are certain) and take a very simplified 1 driver with only 2 possible paths (A & B) scenarios that will play out definitively in 1 year.  Path A is very likely (let’s go with 75%, implying Path B has a 25% chance of occurring) and will lead to a good return (say 50%).  Path B is far less likely but the result would be a major decline in the stock (say -70%). 

Exp. Annual Return (Position) = Prob (A) * Exp. Annual Return (A) + Prob (B) * Exp. Annual Return (B)
In our case; Exp Return = 20% = (0.75 * 50%) + (0.25 * -70%)

Overall, as the calculation above shows, the expected return from this position would be 20%.  While Path B is potentially terrible, its relatively small probability only resulted in the idea becoming less attractive.  However, even considering this, the position has a potentially an attractive return and thus the analyst may well go to his PM to pitch the idea.  Given the infallibility of the analyst (sadly, in this instance only) and the attractive return, the PM should put the position into the portfolio, right?

Well no, not necessarily.  Why? 
Well, here is where Our Man sees the PM and Analyst paths diverge. 
In all likelihood Exp. Return (B)  figure more heavily into the PM’s decision than the analyst’s.  The reason is simple, rather than look at each position on a stand-alone basis, the PM should consider the portfolio (and all its underlying biases) as a whole.   The skill-set to do this is clearly different as it requires an understanding of the portfolio’s biases, both intended and unintended, as well as an understanding of how others might see the biases of the portfolio.

-  The intended biases are easily understood; at the simplest level, imagine the driver was Real Estate prices and prob (B) was the probability of falling real estate prices.  If the PM knew that there were numerous positions in the book that would suffer from falling real estate prices it may not be sensible to add the position to the book with that same risk.  i.e. we have enough of that risk, and are getting better bang for our buck elsewhere.
- The unintended biases are more complicated, even in our simple world.  Imagine a 2 company portfolio.  Company A is a US Copper Company and its major risk is a fall in global demand for copper.  Company B is a French Telecoms Equipment Company, and its major risk is that the 3G networks that it has contracts to supply base stations for may get built out more slowly.  These two companies don’t share any obvious intentional risks; they’re in different countries, industries, sectors, and copper/base stations are massively correlated.  Yes, but…the unintended bias may be that they’re both plays on the same underlying thing – e.g. the base station company’s major contract is to build out a network in China, who’re also the marginal buyer of copper.  Hence, the addition of the new position may well increase an existing bet on China’s growth.
- The importance of the view of others:  While the analyst may be 100% right on all of their analysis, if the market views the drivers as something different (e.g. are using the Copper company as a proxy for investing in China, rather than caring about copper’s supply/demand characteristics) then it stands to reason that the behavior of the stock price may bear no resemblance to the analyst’s expectations (i.e. people become less bullish on China, so sell the stock, even though demand for copper is increasing).

That’s genesis Our Man’s view that the starting points of the analyst and portfolio manager should be different and the need to think about and build portfolio management skills to complement analytic ones.  Some more thoughts on portfolio management, in the coming week…

2010: Glimmers of Hope

- Private Sector takes up the slack
While it’s been clear that a lot of demand in Q3 and Q4 has been government driven, the idea is that the government stimulus is only to keep the economy chugging along until private demand is ready to takeover.  I think it’s clear to most that over the last 12month fear of the recession has receded, wealth has increased (in at least that people’s investments/retirement funds have risen, and house prices have stabilized for the moment), and the rate of redundancies/firings have decreased.  This has led to improvements in confidence, and shouldn’t this confidence show itself up in better business conditions, leading to the virtuous circle of production, profit, increased employment and increased demand.  That’s the hope. 

- Consumer Spending
During 2002, Our Man’s first boss used to constantly tell him “Never doubt the US consumers’ ability to spend”!  At first, Our Man put this down to his boss’ French background and seeming disdain for spending money on anything other than cabs, style and French food.  However, he quickly learnt it was useful advice – yes, the US consumer could spend their way down to a 1.4% annual savings rate (May-08).  While this annual rate has risen to over 4.5% as of November, that level is so 1990’s and habits are hard to break!

- The V-shaped recovery
The above are key premises behind the V-shaped recovery; it’s the way business cycles work, people get too excited at the top, produce too much, then have to make adjustments when demand comes in lower, so cut costs (and the biggest cost is staff), right the ship and boom…off we go again.  It’s happened in every recession since the War…and if you look at the numbers, the bigger the fall the bigger the comeback.  So stop whining about how this time’s a credit/solvency crisis, and look at history (excluding the Depression, and those crazy Japanese, since they were one-offs that can’t happen here)…the V’s the way it is!

- Stimulus II: The Return of the Thing-That-Shall-Not-Be-Named
But just in case there’s any sign that the private sector isn’t quite ready to take up the slack, Our Man fully expects the government to do the only thing it knows – throw money at the problem, and hope it disappears.  However, “Stimulus” is bad politics, 2010 is an election year, so don’t expect the word Stimulus to be anywhere near anyone’s lips.  Instead it’ll be subtler, nicer and happier version of Thing-That-Shall-Not-Be-Named where it’s all about the government helping citizens make good choices for the benefit of America – you know what I mean; “You really should buy that energy efficient washer/dryer, and here’s a pretty little government rebate to help you do that”, “Weatherize your home; Yes, We Can give you a rebate check for that”, “CHANGE your light bulbs to these new energy efficient LED ones, and we’ll give you some change to help with the cost!”, etc

- The FED
Hey, it was never a solvency problem, just a liquidity one…and the one thing the FED has mastered over the years is providing liquidity.  Buying $1.25trillion of mortgage securities for crazy prices using cold hard cash is no problem for the FED, which plans to complete that by March 2010.  While the FED claims most of its liquidity provision will be completed in March, Our Man expects they’ll find some exceptional circumstance or need to temporarily keep doing it either directly or indirectly (hello Fannie and Freddie). 

- China
Our Man can hear your collective “Huh”, given his often snide remarks about China and its prominence in the Fingers of Instability list.  But hey, you know what, maybe Our Man is just plain ole wrong – perhaps the Chinese have built a better mousetrap in terms of this whole running an economy thing!  And if they haven’t, well their ability to throw money at problems makes the rest of the world look impotent.  A c$575bn direct stimulus program and a 2009 quota set for bank lending (driven by the state-controlled big 4 – how nice it must be to have banks do as you tell them) of $1,300bn, equates to a 40% of direct and indirect GDP stimulus in 2009.  Now that should get your economy moving…and while 2010 won’t be as big, it’ll still be might impressive!

- Valuation
Another round of “Huhs”, as Our Man has been muttering about an expensive market.  Well, yes…the Case-Shiller PE-10 and Our Man’s forward-looking model screams expensive, with a P-E of c23x compared to the average (of c16.5x).  But the model also suggests the market’s positively cheap compared to the last 10-years (average 26.67x).  The reality is most people don’t look back beyond 5-years let alone 10-years…