HUMMONEY - Seduced by Language (Perspective)

- by Greg Lewin

We so often get in the habit of being channeled by the media into narrow-band thinking. Language enters the mainstream and from it commentary and analysis evolves.  Take a recent contribution to our investing lexicon: de-risking. 

What does that mean and where did it come from? Does it imply that we know what represents risk at all times, therefore, we always have the antidote handy? Does it mean that we should actively seek risk in and of itself at times? Quite frankly, I’m pretty sure it means that when you charge fees this high in the financial industry for investing, and you don’t know what to do you better come up with a far slicker name than `I’m selling stocks and putting it in cash’. But the danger of this new nomenclature is that it creates a new normative around which investment discussion begins, and the surest way to come to a poor conclusion is to start with a faulty or misleading premise.

Another widely misused term in investing is - value. It is often used to not only support its presence but to rail against its absence. The notion of value is often reduced to small themes such as simple financial ratios, to define its boundaries and to divide those who have it from those who don’t.  It is in fact the simplicity of these arguments that form the core of the danger for investors.

Value: (def.) attributed or relative worth, merit or usefulness. To start, the definition as presented by Random House seems neither specific nor narrow.  So let’s try to dissect how Wall Street wants us to proceed. Value investing tries to suggest a pattern of stock selection which identifies that which is mispriced relative to worth. Often this includes stocks selling at low multiples of earnings, book value or sales relative to perceptions of worth in the future. Why should we allow this term to be so narrowly bounded?  If one is a value investor does that imply others are not? Can you tell me the investment strategy that actively dismisses the search for relative worth?  So the question is, what is value?

To define what is currently of value one must best identify future worth. So let’s say you are an amazing biologist and know enough about the science of a particular disease to predict the worth of a particular company’s science in the cure of a serious disease. Might that highly priced stock nevertheless still be a potential value? In this case, although the financial metrics of a stock may appear rich they in fact could be attractive and therefore it is fair to argue this particular investor to be a value investor.

It is my contention that all investors are value investors.  In fact it would be insane to presume they were not. It is a simple matter of how they see the future and how their investment will be valued as events unfold. Now even if this argument were accepted, the “true” value investor would argue against its broad application, seeking defense in the thought that true value investors limit their risk. So now we must ask, how can one measure risk?  I presume risk control is what is necessary when things go wrong.  For example, investors with Bernie Madoff did not forecast theft when evaluating risk and therefore predictions of value turned out a bit askew.  So if by definition things are not as planned how can you begin to redefine worth?

I would contend that value is not a style or class of investments, but rather an ongoing process, one which actively monitors and analyzes facts in the context of a well organized plan. But the real intent of this article is to shake investors from conventions created by the misuse of language. Language can effect perceptions which then impacts behavior which ultimately leads to risk. The investment puzzle is complex enough. Try to detach yourself from the noise created by the media and Wall Street to find the best path for your investment success.     

 ---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.

HUMMONEY - The Risk of Interesting Investing (Perspective)

-- BY GREG LEWIN               

Research recently produced by Munich Re (a reinsurance company whose job it is to study risk) and reported in BusinessWeek reveals that traffic fatalities have dropped sharply with the introduction of safer vehicles with modern safety features.  However, the rate of serious accidents has not dropped. Their conclusion was that “We introduce risk-mitigation devices that are supposed to make life safer and then we change our behavior to make life more interesting.”   

Well, in investing risk is not interesting and seeking it without a meaningful change in reward is insane. The business of investing is very straightforward:  the goal is to acquire as much reward with as little risk as possible, and when you have unearthed the great anomaly in these two factors, place a meaningful amount of capital in this investment because these opportunities are rare. Investing is very cold.  It is simply about this ratio of risk and reward.  But the subtlety which will determine success and failure is all about the confidence you have in your assessment of this ratio and the probability of the outcomes of each factor.

In the extreme, confidence and capital commitment can be more important than being right or wrong. As an example, let’s say you make 100 investment decisions in which you are right the first 99 times, but each time you only invest $1. You only are wrong regarding the 100^th investment but you invest $100.  You lose. I understand this is an extreme example, but my experience has shown me that conviction plus capital commitment have consistently been more important decisions than wrong or right. However, it is also my experience that judging risk is infinitely more complex than evaluating reward. Let’s be honest - reward is all about the fun parts.  This is the path of fantasy and fiction where all your dreams come true, products sell, research succeeds, the economy grows and management plays it all perfectly. Risk, however, is the salt on the wound, competition, management mistakes, closing capital markets and business and consumers retrench.  All of this should change our behavior and not because it is interesting.

Finding a very attractive risk/reward ratio is important, but again my experience has shown me that only when the risk is low will you find an investment worth serious capital commitment and that is where the real money is made.  Now if you consider that the financial industry of any country is populated with reasonably bright, overly aggressive and hardworking people, it is reasonable to assume that when your assessment of risk and reward is very attractive, something is probably wrong because everyone is looking for this same anomaly and by definition have crowded out this exceptional return. There are exceptions, of course, but when you find them make sure you examine them extra carefully. As a rule, if you can find an investment that offers 3 times the reward of the estimated risk and can realize that result in the next 2 years, this may be worth your investment of time and energy. I share these proportions and timeframes for specific reasons derived from my experience because inevitably investors are overly optimistic in assessing the parameters that create reward and not adequately pessimistic about those which form the basis of judging risk.  To ensure a margin of safety it is good to start with a disproportion of risk to reward. Secondly, the further out in the future you are forced to forecast the less likely it is that your accuracy will remain true. Therefore, it is best to create a series of shorter term plans with embedded risk and reward parameters rather than longer term which may provide for a loose examination of performance leading to unmanageable losses.

The game is simple and sterile:  risk, reward and capital commitment. But the important nuance is managing behavioral disposition toward risk because investing shouldn’t be about making life more interesting, but rather about possibly facilitating a more interesting life.

---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.  

HUMMONEY - A Basic Misunderstanding (Perspective)

- By Greg Lewin

A common mistake made by most investors is to associate the movement of a market or a stock with a particular piece of information that has just made its way to the public consciousness.  Let’s assume some latest and greatest piece of economic news was just released by the government and the market reacts violently. The first mistake an investor could make is to assume a cause and effect. It is my opinion that the majority of the time the market is not reacting to the news but rather is responding to its state of under or over valuation in a period that may be subject to change.

You may logically ask how I could possibly make such a broad and bold statement.  This is easy. Think about it, in our worldwide interconnected economy is it at all possible that any 1 piece of information, in 1 country, at 1 single point in time could arguably alter the sustainable economic prospects of ours and other linked economies by the hypothetical 2-3% change reflected in the stock market on that given day? If we were capable of measuring the aggregate change in worldwide market values versus the economic weight of this single news item we would soon see the limits of this connection.

I would argue that an attachment to individual information is a very poor predictor of market behavior. But don’t tell this to the abundance of media sources arrayed to pontificate on the news of the day, regardless of how limited in overall value it may be. Rather an awareness of market valuation is a far more reliable method for managing daily market news flow. The issue is rarely an individual piece of news.  Rather, it is the margin of safety built into the market to handle the news.

It is not coincidence that great market declines follow extended periods of market appreciation when expectations are high creating excessive valuations for stocks. For it is at these moments that the market is least capable of adjusting to bad news. Just as we see markets become increasingly resilient to bad news at market bottoms. The question is rarely the news because in and of itself it is illogical to believe that any 1 piece of news could alter market valuations as much as they do. More importantly and more sustainable it is market valuation itself that ultimately will determine market reaction and behavior because the sustaining question is, has the market built in a set of shock-absorbers to digest unexpected news.

Your bigger problem as an investor is that when you incorrectly correlate market behavior with the news of the day you will instinctively look for that pattern again and in my opinion base your investment decisions on faulty logic which could lead to a pattern of mistakes.

My advice is train your thoughts on durable values, such as fundamental market valuation, rather than disposable information, like the news of the day to properly adjust the probability of risk and reward when making an investment decision.      

- The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.