Buying Businesses, Winning in Different Ways, and Uncommon Levels

Welcome to the Fortnightly, a digest of interesting reads from around the investment ecosystem.

Buying businesses

Some stock market investors are buying stocks, while others are buying businesses.  Time horizons differ and the rationale for a purchase can vary from a trading strategy to getting exposure to a factor to holding that business forever as if you were the sole owner.

Private equity funds are clearly buying businesses, although their holding periods are rather short compared to true long-term owners.  There are also multi-decade and perpetual funds with very long horizons.

Everyone in the buying-businesses line of work needs to do due diligence and faces the challenge of sorting through the information that’s provided, as well as discovering the critical bits that aren’t.  A big company probably has a well-crafted narrative (so “cracking the narrative” is a high-value skill, as it is when analyzing asset managers).  Smaller firms usually aren’t as polished and organized, presenting a different sort of puzzle.

Permanent Equity, which invests thirty-year committed funds in small to midsized companies, recently made public its due diligence process, including a seventy-page document full of details.  Chief Investment Officer Tim Hanson explained the reasons for sharing its approach.

The craft of due diligence involves more than a checklist, since there needs to be discovery of a range of attributes that don’t fit neatly between the lines, that aren’t anticipated by buyers or willingly shared by sellers.  But the thoughtfulness and depth of the Permanent Equity approach ought to serve it well in the marketplace and should be considered by others who evaluate organizations.

On a related note, “search funds” have become popular of late.  See, for example, “MBAs Are Spurning McKinsey to Buy Small Companies” by Matthew Boyle of Bloomberg.  But the dream and the reality of running companies are sometimes far apart.  Some of the disconnects are covered in “Check Your Strategy and Capital Allocation Aspirations,” from Trish Higgins and A.J. Wasserstein.

Two ways

The latest memo from Howard Marks looks at two routes to success — fewer losers or more winners.  As he has before, Marks uses the image below to illustrate general investing principles, equities, fixed income, and the stylistic choices of avoiding losses or going for winners.

But Marks is “convinced the potential to improve on that through skill does exist in some markets and some people,” that alpha lies in “the ability to alter the shape of the distributions in the graph above so they’re not symmetrical,” as shown here:

Now we just need to find those markets and those people (and not confuse the random noise of performance with an ability to bend the distributions on an ongoing basis).

Anniversaries

It’s that time of year.  In the last couple of weeks we’ve “celebrated” the 25th anniversary of the collapse of Long-Term Capital Management (LTCM) and the 15th anniversary of the Lehman bankruptcy.

Looks back at LTCM include a posting from Marc Rubinstein (the pre-paywall section has the basics) and a Bloomberg article by Sonali Basak that includes an interview with Victor Haghani — and a reminder that the event marked the institutionalization of “the Fed put.”

That put was very much in evidence ten years later.  But what has changed since the financial crisis?  Mark Rzepczynski offered his opinions about what has changed (and what hasn’t), including that “The Fed has created the foundation for a new financial crisis.”

Other reads

“Honey, the Fed Shrunk the Equity Premium: Asset Allocation in a Higher-Rate World,” AQR.

Where “cash-plus” strategies charge performance fees, they should be on returns above a cash benchmark, just as long-only managers should be evaluated against an appropriate market benchmark.

“The Research and Development Factor,” Larry Swedroe, Alpha Architect.  “The empirical evidence demonstrates that the R&D premium remains an anomaly in all models.”

“Panel: The RIA industry is headed into a war for talent,” Daniel Gil, Citywire RIA.

A prolonged shortage of financial advisors may push hiring competition among RIAs into an all-out industry war which could sharply drive up costs to recruit and retain employees.

“The China paradox: underrepresented or too dominant in emerging market equities?” Marc Bindschädler, Vontobel.  Given uncertainties about China’s future — and its “dominant but also underrepresented” weighting in market indexes — consider five possible “patterns of investor response.”

“An oral history of the fear index.” Robin Wigglesworth, Financial Times.

“Democratising volatility trading” is something that sounds cute in an options exchange pit or Goldman Sachs trading floor, but perhaps there are just some things that shouldn’t be democratised?

“How Andy Golden Reinvented the Endowment Model for Princeton,” Alicia McElhaney, Institutional Investor.  “One team, one dream” — with an “odd and secret and unstable” decision process for what goes into the portfolio.

“Using AI in an earnings call,” Joachim Klement, Klement on Investing.

What the research found was that executives tend to hide behind boilerplate answers more when they are delivering bad news.  If they are discussing problems at their business, they obviously don’t want to go into too much detail about how bad the situation really is.

“Investment Advisers: Assessing Risks, Scoping Examinations, and Requesting Documents,” Securities and Exchange Commission.  Which firms get examined, what areas are in focus, and the (pile of) documents that are usually requested at the start.

“Thematic Analysis: Emerging Risks in Private Finance,” International Organization of Securities Commissions.

Private finance has largely grown in a period of accommodative macro-financial conditions.  This has now changed.  The sector may be tested in the medium to long term and could respond in ways that uncover hidden risks.  It is evident that private and public markets are intertwined to the degree that any one market event could have implications across both markets and, potentially, the broader financial system.

“The Real-Life Inspiration Behind The Bonfire of the Vanities,” Joseph Mysak, Bloomberg.  Cutting the cake and keeping the crumbs.

Narrow perspectives

“If everyone is thinking alike, then no one is thinking.” — Ben Franklin.  (See also Alfred Sloan.)

Uncommon levels

These charts were posted on LinkedIn (top and bottom) by Brian McAuley of Sitka Pacific Capital Management.  They offer historical context for the management of portfolios (and the behavior of clients regarding investment products of various stripes).

Is this a permanent change in the economic and market regime that started in the early eighties?  That’s the big question of the day, along with the corollary:  Which businesses, instruments, and strategies are untenable if that’s the case?

Postings

“The Paradox of Manager Selection Practices in a Changed World.”  The persistence of performance by the managers of alternative investments has declined over time, so the heuristics of the past don’t apply, and different ideas and questions become more important in manager selection.

“Becoming a Learning Organization.”  Lessons from seventy years of the CIA’s efforts to study the intelligence process and build up a fund of knowledge to help it learn from its successes and failures.

All of the content published by The Investment Ecosystem is available in the archives.

Thanks for reading.  Many happy total returns.