February 2021
“But larger funds lag”
The questionable hindsight of backtesting
If you can’t beat ‘em, join ‘em
Better for markets: Chiefs or Buccaneers?
Degree of Difficulty
Increasingly, investors have become concerned about high valuations and the perceived Likelyhood for lower returns from equities moving forward. With the Tokyo Olympics approaching this summer, we have a fitting opportunity to revisit the 1998 Berkshire Hathaway annual meeting in which Buffett contrasts Olympic diving with investing.
In Olympic diving, each type of dive is assigned a degree of difficulty factor which is multiplied by the execution score to get the final score. In this way, divers who attempt more difficult dives are rewarded with higher possible scores.
But investing is not scored like that! Stories occasionally make the news where investors make significant profits from complex trades. Rightly or not, attention rains on the supposedly insightful investor for seeing market opportunities and capitalizing on them with sophisticated trades. Buffett advocates for simplifying both the number and the nature of the decisions we make, noting that investors get paid the same for easy decisions as for hard decisions. Perhaps ironically, it takes more work to find the easy decisions, but that extra work is worth it.
Munger, with his pithy charm, closes this way:
“If our predictions have been a little better than other peoples’, it’s because we try to make fewer of them.”
—Charlie Munger
This is not new advice from Buffett either. Thomas Tull, founder of Tulco LLC which is a holding company like Buffett’s Berkshire Hathaway, was recently interviewed and shared this wisdom from a meeting with Buffett:
"There was a moment," Tull says. "Where I was describing and talking through the business model [of Tulco] and how I thought about something."
"I said, 'What we're trying to do is be smart about,' and [Buffett] stopped me and said, 'I gotta be honest, for years, Charlie and I have always asked, 'What's the dumb thing we could do here?'"
"I kind of laughed, and he said, 'No, I'm dead serious. We always ask. We don't want to be in the clever pile. What what could we do here that would be the dumb thing, and how do we avoid it?'" Tull says. "Honestly, it actually has had a fair amount of impact on the way that I assess and think about situations."
I don’t want to be in the clever pile either.
A stock picker’s market?
Is this a stock picker’s market? Eduardo Lecubarr, chief of the Small/Mid-Cap Strategy team at JP Morgan, thinks so. Lecubarr affirmed his team’s outlook that “2021 will be a stock picker’s paradise with big money-making opportunities if you are willing to go against the grain.” This favorable view of stock picking is pervasive, and of course stock pickers naturally think virtually every market is a stock picker’s market, nothing new here.
What is the best strategy to beat the house edge in a negative expected value game? Bet everything on one decision.
Everyone thinks they have an edge! They just know they are among the few investors who can reliably pick the stocks that will outperform the broader market index. Overconfidence, fundamental attribution error, illusion of control, and other well-known biases lead investors to irrationally think they have an edge. Those probabilities (Likelyhoods) inevitably and predictably play out against them in the long run.
I’ve written about the mathematics of making fewer decisions in Blackjack, in which the player has a negative expected value against the house. What is the best strategy to beat the house edge in a negative expected value game? Bet everything on one decision. As more hands are played with a negative expected value, the Law of Large Numbers ensures that the casino will realize its theoretical house edge, so the best (but still losing) strategy is to minimize the number of hands one plays and take your chances at getting lucky.
As investors trade more and more frequently in positions for which their overconfidence conceals the actual negative expected value, they increasingly ensure their long term underperformance. This is why day trading, stock picking, and other such strategies have low long-term Likelyhoods of outperforming index funds.
In his 2018 paper Do Stocks Outperform Treasury Bills?, Hendrik Bessembinder found that the best-performing 4% of listed companies explained the net returns of the entire U.S. stock market since 1926, which helps explain why active strategies with poor diversification usually underperform market indexes.
Ben Felix explains the obvious:
“That means that you would have been better off taking no risk at all, than holding 96% of the individual stocks in the U.S. since 1926. I’d call your chances of picking a winning stock pretty bad.”
So no, neither this current market nor any in recent history or the foreseeable future, are Likely to reward stock pickers collectively. The data are clear - any outperformance of individual stock pickers is almost certainly attributable to luck.
Then what about ETF-picking?
Not surprisingly, chasing performance via ETF-picking leads to similar underperformance as stock-picking. One must look at performance plus process, and the overconfidence implicit in ETF-picking is a poor process.
Anyway, here’s a Barron’s article about the rapidly emerging competitors following the ARK family of ETFs that have seen eye-popping inflows: ARK ETFs Were Hot, And Competitors Emerged. Now They're All Falling.
“As the Wall Street adage goes, when the ducks are quacking, feed the ducks. Fund companies took note of ARK’s inflows, and have been rolling out similarly specialized, ARK-like funds that focus on innovative and disruptive companies.”
With massive inflows also comes massive outflows, as ARK has seen recently. Performance-chasing investors who quickly pour into hot stocks and ETFs are very Likely to quickly pour out of those stocks and ETFs at the first sight of a downturn, which is the primary explanation for ARK’s outflows. Comes with the territory of ETF-picking.
Quick Hits: GameStop
In case you have found better uses of your time than reading anything with GameStop in the headline, here are some perhaps lesser-known Quick Hits on the meme stock mania:
Jordan Belfort has thoughts on GameStop:
Brokerages are shutting down trading because they have liability as fiduciaries WHEN (not IF) share prices crash back down to fundamental levels.
There has been illegal activity by Redditers. A smart lawyer will be able to go through subreddit logs and make the case of collusion, posts like “stay strong, we have to do this together” and “stick with it, we’re in this together”.
Targeting companies with high short interest by using leveraged call options is a good strategy, but Redditers should choose their targets a bit more wisely to find businesses that are not so obviously bad. They will make even more money that way.
Tilray, the Canadian pot producer, in 2018 saw it’s stock price spike 1,400% after a similar short squeeze as GameStop and AMC are now experiencing. Tilray’s CEO Brendan Kennedy offered this advice:
“My advice to those CEOs would be that, at times like this, your company is not your stock and your stock is not your company,” he said. “Keep it all in perspective as these very unusual market dynamics are taking place.”
You know these are strange times when Peter Lynch’s tautological advice seems questionable:
“The basic story remains simple and never-ending. Stocks aren’t lottery tickets. There’s a company attached to every share.”
Those shorting GameStop analyzed the fundamentals and concluded that the shares were priced too high. They perhaps overlooked, or underweighted, the effect of demand on prices and overcrowded short trades. Some argue that with price surges like we’ve seen in meme stocks, the markets cannot possibly be efficient. One could say that WallStreetBets found and corrected a market inefficiency - the market is working! This still will end badly for those holding the bag at the end. Nevertheless, here is a PSA to all shorts: don't take large leveraged short positions then attract attention to your position, that game has most definitely changed.
Hedge funds are paying big money to scan Reddit for the next coordinated short squeeze. Signaling arbitrage could hinder the success of future WallStreetBets takedowns. Wall Street is keeping very close tabs on WallStreetBets. Here's how
GME reveals another risk of stock picking:
"The January short squeeze illustrated how the combination of leverage and crowding creates risk both for hedge fund returns and broad market performance," David Kostin, Goldman's head of U.S. equity strategy, said in a note." Hedge funds that hunkered down after GameStop are now missing out on market gains
Although not in response to GME, Warren Buffett as usual has evergreen insights:
"Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well."
—Warren Buffett
Fortune Tellers, Part II
In December we reflected back on 2020 by comparing market forecasters with fortune tellers - and argued that market forecasters make fortune tellers look good(!) To kick off 2021 let’s dig into the (lack of) evidence behind market expertise, shall we?
Ben Felix of PWL Capital, the Rational Reminder podcast, and his popular Common Sense Investing channel, gives us this must-watch gem titled Why You Should Ignore Market Experts:
As much as we crave certainty, it rarely exists, and it definitely does not exist in the world of financial markets, where returns are driven by events that cannot be consistently forecasted. Market experts want you to believe that their insights can help you make better investment decisions. Sell this. Buy that. It may be interesting to listen to market experts, but should you actually believe anything that they say? I’m Ben Felix, associate portfolio manager at PWL Capital. In this episode of Common Sense Investing, I’m going to tell you why market experts are one of the worst sources of financial advice.
One of the worst sources? Really? Consider the evidence examining two comprehensive efforts at aggregating and analyzing the predictions of so-called stock market gurus, then decide for yourself:
Stock Market Timing: Why the odds are strongly against it (and why investors should fear missing the upside, not avoiding the downside)
The CXO Advisory Group followed the forecasts of 68 stock market experts from 2005 thru 2012, during which they made a total of 6,582 forecasts for the US stock market. Those forecasts were then compared against the S&P 500 index over the future intervals relative to each forecast. Their aggregate accuracy of all forecasts? Less than 50%, ouch.Swedroe: Checking In With The ‘Gurudex’
“Thanks to research compiled by the team at InterTrader, we can examine the 2015 stock market recommendations from 16 leading investment banking firms. They produced what they called the Gurudex.”
This study measured both the accuracy of the forecasts as well as the overall return for a would-be investor acting on all of the expert’s forecasts. The 16 institutions that they tracked, including heavyweights RBC Capital Markets, BMO Capital Markets, Goldman Sachs, and UBS, delivered an average stock prediction accuracy of 43%, ouch. Only 4 institutions had greater than 50% accuracy: a Japanese institution batted 60%, and the other three had a 53% barely-better-than-a-coin-flip accuracy. The accuracy numbers drop sharply from there. If a would-be investor acted on every prediction, that unfortunate investor would have earned a -4.79% return while the S&P 500 was relatively flat at -0.69%.
To state the obvious: Market experts sometimes act on motives other than accuracy. For one common example, making extreme forecasts - “Market crash imminent!” - often attracts attention to their institution or publication that they can monetize in other ways despite the less accurate forecasting. If markets actually crashed, they will be seen as a responsible, insightful manager; if markets did not crash, well, it was prudent risk management and nobody will remember the incorrect forecast anyway.
So yes, ignoring “market experts” is very Likely the prudent response.
ONE MORE THING…
“But larger funds lag”: Majority of hedge funds see positive performance in January but larger funds lag
The questionable hindsight of backtesting. Be skeptical of any backtesting that starts in 2008. Investment Strategy To Outperform The S&P 500
If you can’t beat ‘em, join ‘em. Patrick O’Shaughnessy tweeted “The future of index investing is customization”.
Better for markets: Chiefs or Buccaneers? There's always a random deviation to be found with backtesting. Super Bowl, Chiefs vs. Buccaneers: Market data points to one winner
The information and opinions contained in this newsletter are for background and informational/educational purposes only. The information herein is not personalized investment advice nor an investment recommendation on the part of Likely Capital Management, LLC (“Likely Capital”). No portion of the commentary included herein is to be construed as an offer or a solicitation to effect any transaction in securities. No representation, warranty, or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained herein, and no liability is accepted as to the accuracy or completeness of any such information or opinions.
Past performance is not indicative of future performance. There can be no assurance that any investment described herein will replicate its past performance or achieve its current objectives.
Copyright in this newsletter is owned by Likely Capital unless otherwise indicated. The unauthorized use of any material herein may violate numerous statutes, regulations and laws, including, but not limited to, copyright or trademark laws.
Any third-party web sites (“Linked Sites”) or services linked to by this newsletter are not under our control, and therefore we take no responsibility for the Linked Site’s content. The inclusion of any Linked Site does not imply endorsement by Likely Capital of the Linked Site. Use of any such Linked Site is at the user’s own risk.