Sound and Fury

JPMorgan Chase announced it had a $2.3 billion trading loss last Friday, and politicians and the press are having a field day.  

To put this loss in perspective, the company made almost $5.4 billion last quarter, and $18.8 billion over the last 12 months.  That $2.3 billion loss occurred relative to an asset base of $2.3 trillion (the loss was 0.1% of assets), with $190 billion of equity (the loss was 1.2% of equity), $256 billion of long term debt, and $78 billion of short term debt.  In other words, JPMorgan would have had to lose $1.1 trillion before even one depositor with the bank would have been at risk.

Businesses will have losses as well as profits, and in this case JPMorgan’s loss doesn’t and couldn’t possibly impact the solvency of the bank much less impact depositors or tax-payers.  

Politicians and the press are generating a lot of sound and fury at present, but don’t seem to know or care what kind of business JPMorgan is, or whether it has put tax-payers in any way at risk.  

The reality is that a $2.3 billion trading loss is egg on the face of JPMorgan and Jamie Dimon, but has little impact on the viability of the bank, depositors or tax-payers.

To assume–as politicians and the press do–that regulators would have prevented this from happening is to forget the last 200+ years of banking regulation, which always has and always will manage to close the barn door long after the animals are gone.  

Regulators are human beings, too, and just like the hard-working people at JPMorgan, can and will make mistakes.

The assumption that more controls and regulations would prevent such events is pure fantasy, and is more likely to create than solve any problems.  Chasing down minor events like this loss that will have minimal impact on equity investors that have knowingly and voluntarily put capital at risk is worse than a waste of time–it’s counter-productive.

JPMorgan’s loss is bad for JPMorgan shareholders, not bond-holders or depositors.  The press and politicians are eager to use this event to call for increased regulations and control, but a short evaluation of JPMorgan’s capital position and the “success” of previous regulatory reforms should make people pause and think before listening to the press or politicians.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Sound and Fury

Quantity AND Quality

When I offer my daughter the option of ice cream or cake, she frequently replies she’d like ice cream AND cake. To her, I offer a false alternative when the “OR” can very clearly be an “AND.” In this case, her reasoning is sound.  There is no need to give in to the tyranny of “or,” instead we should–as Jim Collins recommended in Built to Last–embrace “and.”

I see this every day while investing. Should you invest in Growth OR Value?  Properly understood, this is a false alternative, because growth is one of the most important inputs to value.  

The value of a company is based on it’s future cash flows. If those cash flows are growing, the company is clearly worth more than if they are not (you get more cash flows over time, all things equal). Value is based on Growth, so Value AND Growth must be understood.

For example, if you want a 12.5% return over the long run, you should pay eight times earnings for a 0% growth company, and 15 times earnings for a 6% growth company (almost twice as much!).  Growth has a HUGE impact on Value.

Another mistake investors make is to focus on either Quantity OR Quantity. Once again, Quality is a key input to Quantity. For instance, a company with high barriers to entry and superior management is more likely to achieve quantitative measures of performance like sales per share, profit margins and growth rates than a company without these qualities.  

The degree of certainty that a quantitative result will occur is a qualitative factor, so the quantitative result is driven by the qualitative situation. Once again, Quality OR Quantity is a false alternative–you must pay attention to Quality to correctly grasp Quantity.

Just think about Coke. An inexpensive, frequently purchased product with addictive qualities (caffeine, taste, habit) is much easier to quantitatively predict than an expensive, infrequently purchased product with no addictive qualities (like washing machines). Quality heavily impacts Quantity.

Successful investing is about understanding the nature of each investment. To successfully do this, you must focus on Growth AND Value, Quality AND Quantity. Don’t suffer from the tyranny of “or,” do as my daughter does and embrace “and.”

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Quantity AND Quality

Picking a money manager

It has been well documented (by organizations like Dalbar as well as tons of academic research) that investors get lousy results over time. 

One reason is that they try to do the investing themselves, but lack the knowledge, skill or temperament to invest successfully. Another reason is that they’re lousy at picking money managers. I can’t help with the first problem–it’s up to each person to be honest with themselves about their own abilities and results–but I can help with the second: picking money managers.

There are basically two ways to pick a money manager:

  1. Examine past results
  2. Examine a manager’s process to see if it is a good one

The benefit of examining past results is that it can be done quickly and seems objective. The problem is that separating random luck from real skill is extremely difficult. 

Every money manager’s past record includes a component of randomness, or luck, and a component of skill. How do investors know whether they are seeing a record due to luck, or skill? They don’t.

Investing results are much more random than most investor recognize, especially over the short term. Looking at a record of less than 3 years is likely meaningless. Records of more than 3 years are more meaningful, but even outstanding money managers can under-perform for 5, and sometimes even 10 years!  Correlatively, some managers have great records that don’t last because they were lucky, not skillful. 

Most investors examine past records, but their ability to pick good managers by looking at investing results is terrible. Even professional consultants and investment committees filled with experts get this wrong much more often than right.

Examining past records has a dreadful track record of successfully picking managers.

The other option, examining a manager’s investment process, is much more time consuming, but has a much better chance of being done successfully.

Specifically, there are two measures that seem to be both reliable (persistent) and valid (actually lead to the desired result).

The first is called active share, which is a measure of how different a money manager’s portfolio looks from the general market. To beat the market, you have to be invested differently than the market. You want to find a manager whose portfolio looks different than the market, and therefore has high active share.

The second measure is called tracking error, which is a measure of how differently a manager’s portfolio moves relative to the market. If a manager is all in cash, his portfolio will not move up and down with the market at all, and that leads to high tracking error. A manager who owns the same stocks in the same proportions as the market will move in lock-step with the market, and that leads to low tracking error. 

A manager with a good process tends to have moderate tracking error, which means his portfolio neither moves precisely with nor against the market. Such a manager doesn’t try to time market segments (all technology or all energy), nor does he try to pick “winning” asset classes (all cash or bonds to get in and out at the right times). A good manager picks investments that don’t mirror the market, but that do tend to move in the same general direction as the market over time.

Most investors use the wrong methodology to pick money managers and their results suffer. Instead of looking solely at past records and hoping they can guess whether that record reflects luck or skill, investors should look at a manager’s process. 

If a manager picks investments different than the market (especially if those investments have been carefully analyzed), and doesn’t try to time segments or asset class exposures, you’re likely to have found a manager that will get good results in the future.

Examine a manager’s process, not just their record.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Picking a money manager