Tuesday, January 10, 2017

A puzzle for the risk manager

The last two posts were essentially about picking a value-stock portfolio and managing the risk. And they were lessons that I thought I could implement.

This is stuff I find harder. So I am looking for your input.

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This is the portfolio of a fairly well known value investor in March 2008. I have taken the name off simply because it doesn't help but there was roughly $4 billion invested this way.

To put it mildly this portfolio was very difficult over the next twelve months.


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Sector allocation Positions
Banks - Europe 24% Fortis, ING, Lloyds, RBS
Banks - Japan 14% Millea, MUFJ, Mizuho, Nomura
Banks - USA 8% Bank of America, JP Morgan
Technology - PC & Software 18% Linear Technology, Maxim Integrated products, Oracle
Semiconductor equipment 14% Applied Materials, KLA Tenecor, Novellus Systems
Beer 20% Asahi, Budweiser, Group Mondelo, Heinekin, InBev
Media 15% Comcast, News Corp, Nippon Television
Other 14% eBay, Home Depot, Lifetime Fitness, William Hill
Net effective exposure 127%
Shorts -16%
Net exposure 111%
Cash -11%



The PE ratios mostly looked reasonable and all of these positions could be found in quantity in the portfolios of other good investors. Its just the combination turned out more difficult than average.

Your job however is to risk-assess the portfolio.

Even with the considerable benefit of hindsight how would you analyse this portfolio?

What would you say as risk manager that made the portfolio manager aware of what risks he was taking?

What would you say if you were a third party analyst trying to assess this manager?

What is the tell?

Remember the portfolio manager here has a really good record and the "aura" around them. They are smarter than you.

And yet with the restrospectascope up there is stuff that is truly bad.

They had four European banks making up a quarter of the value of the portfolio. Most European banks went through the crisis hurt but not permanently crippled. Permanently crippled came later with the Euro crisis.

The four European banks here (Lloyds, RBS, Fortis, ING) however received capital injections so large that they were effectively nationalised. If you had thrown darts at European banks it might have taken hundreds of rounds to pick four that bad... They could not have been picked this bad by chance - they had to have systematic errors here.

There is something really wonky about this portfolio - and it is not by chance - so there was something faulty about the way the portfolio was constructed.







John

PS. It is fair to say some of the portfolio (News Corp for example) was awful in the crisis and came back stronger than ever. And some that I would have thought ex-ante high risk (such as the semi-conductor capital equipment makers) turned out okay - having "ordinary" draw downs in the crisis and recovering them since.

PPS. I kept the document this came from because at the time I thought the portfolio was absurd and would end in tears. But some of my thoughts then were wrong too - especially re the semiconductor capital equipment stocks.

58 comments:

Fritz said...

Imho a money manager should:
1) maximise the compounded rate at which the portfolio is growing
2) keep drawdowns low enough to keep clients happy

The way to do so is to find asymmetric upside-downside ratios (weighted by their respective probabilities). Expected returns should be calculated with geometric means - because remaining funds will be used to make further bets. So a 50/50 probability of 20% downside vs 25% upside is a neutral bet. A 50/50 probability of a 90% downside vs 1000% upside is also a neutral bet.

My point is that the key focus for any money manager should be on downside risks. Because some financials can truly offer a 90% downside return if and when a crisis happens (and equity gets diluted). The money manager in your example may not have had the proper perspective to realise the risks of bank stock positions at the peak of a credit cycle. Most value investors simply stay with the heuristic: weighing the strength of the story against how low the PE is. It doesn't always work.

Having close to 50% in one sector is also madness. Few clients can stomach more than 20-30% drawdowns in any given year, so why gamble away your entire business on a single bet?

Anonymous said...

There's no macro overlay on this portfolio. Even if it's hidden in the back of your head, a macro overlay is an important way to cross things off the list and winnow the opportunity set (which is very, very different from using it to make bets on the future).

Can you determine that there's no macro overlay in real time? I think you can. So much in banks, which to me (reductively) are cyclicals that are uniquely built to blow up, says something. You can think that in a sunny environment. Anybody who knows a bit of history knows that it's a risk you don't need to take.

This is not a portfolio that can take an environmental body blow.

memyselfandi007 said...

Seems like 40%+ for one relatively volatile sector is a little too much....

Limiting/managing sector risk (across national/regional boundaries) does make sense.

I guess that also the 2 technology groups have relatively strong correlations and Ebay might be more software or banking than media.

For my taste this portfolio has clearly too much sector concentration, especially regarding the leverage via the short portfolio. But on the other side I am not a famous hedge fund manager ;-)

Sason Torosean said...

Multifactor risk models, (preferably fundamental ones), would tell you about your exposures, which would have hopefully warned how concentrated this portfolio was in terms of its exposures to risk factors. During stressful times, there is a stronger correlation between these factors, so that a shock to one (in this case financials), would propagate fast and deep, adversely impacting the rest of the tightly coupled factors. My money is on the thesis that, due to a high correlation between them at the time, the shock to the financial sector, impacted the information technology sector and consumer discretionary sector quite badly, sending this portfolio down the gutter.

Also in these risk models, value factor is often built based on combination of fundamentals such as P/E, P/B... Often time investors don’t want to pay too high of a price for highly leveraged companies, artificially pushing the value indicators down, falsely conveying value. So, although you might have a huge exposure to the “value” factor (which in theory would fare better during bad times), you also have a massive exposure to the leverage/credit risk factor, which again would have exhibited a large correlation with financial sector risk factor… so it goes as the paragraph above.

Had they diversified across more asset classes things might not have been as bad, but then I wonder how difficult is it, from a practical perspective, to diversify when your stress indicators are high?

-S.T.

Nemo Incognito said...

All massively sensitive to industrial production / curve steepness / inflation. Way you hedge this sort of a book is through calls on bond futures. What kills here is deflation and slow growth, both of which happened.

Ben said...

It is a highly sector-concentrated portfolio with very specific macro exposures that could blow a huge hole in AUM. I don't have perfect recall of the period but a 40%+ collective exposure to banks in and of itself is very concentrated and highly pro-cyclical. On top of that, I see Home Depot, the semiconductor co's and ORCL all of which had pro-cyclical components. Admittedly, in ORCL I recall it having a secular growth element as well (service rev growth) but it appears to be an 18% position so it really matters. My understanding is that the semis were seen as highly pro-cyclical then as well but not an area of knowledge for me. Bottom line, whatever happens for the rest of 08 and beyond (we were bearish then but didn't have to be right about being bearish then, ex ante) this manager is making a concentrated bet on the global economy's interim direction. Meanwhile we had gone a number of years without a major global/regional meltdown. We may not have been 'due' but it was worth worrying about. If other companies in the portfolio had significant debt (eg Comcast) then that, of course, compounds the problem further.

Benedict Treloar said...

The obvious thing I note is an absolutely unacceptable level of leverage for a long-short fund. It should have been fairly obvious from 2007 that banks were heavily exposed to economic conditions, so the 44% of the portfolio in banks had a beta significantly higher than one. The rest of the portfolio isn't exactly low risk either (the type of semicos and tech the fund is invested in look cyclical to me, and we know that media spend dies quickly in downturns) so you have a levered fund, with non-fin equity holdings pretty sensitive to economic conditions, and the financial holdings even more so. I think the beta of the portfolio would have been significantly above 1, and markets declined very substantially over the period

At this point in the cycle, I suspect the manager would have been talking about the positions, particularly in financials, giving him very significant upside optionality ("you can't lose as much as you can gain"). However, the structure of risk capital and regulation means that the "options" have a knockout when mark-to-market NAV falls below zero if if regulators decline emergency liquidity and bail in shareholders, which is what happened. How did he manage to pick all four? I wasn't working then, so I don't know the exact specifics, but I'd imagine that these companies screened for highest value on price-to-book (the slowest-to-update metric). "Deep value" investing relies on you having time to be right; with financials, the mark-to-market condition can mean that you don't have that if liquidity concerns overwhelm solvency.

In summary: massive leverage to economic conditions, with a false belief in the ability for the thesis to survive for long enough for "deep value" to become important.

Martin said...

I am no risk manager, just some immediate thoughts on this:
Because those were not smaller regional banks, the geographical diversification per location of headquarter is not that meaningful to say the least.

111% net is pretty aggressive with already much cash in leveraged business models here: financials.

Risk management depends also on what percent of assets is in this fund?

Why do they need four beer companies? Those are already pretty diversified by themselves.

Josh said...

First thoughts:
-There's a lot of leverage here. Banks are always levered, and I remember being shocked at balance sheets when I got to banking in 2007/2008. An aggregate or sector level total debt to ebitda or cash flow would highlight that this book looks like its more leveraged than a book with a 'margin of safety' might want to be.
-The tech positions look to have a lot of earnings volatility. This reminds me of my ill-timed purchases in cyclicals when P/E ratios have looked attractive at the top of a cycle.
-Inbev had just pursued the leveraging transaction for BUD which I think took leverage to 4-5x.
-No real thoughts on the last component, but you're already at 100% by then.
-There's a decent amount of foreign currency volatility embedded here too that adds a layer of complexity.
-Basicall, in my view, you have a lot of embedded leverage here along with cyclicality in underlying cash flows and a decent layer of currency risk.

Richard Oakes said...

Hi John
To do the task that I would have expected a professional risk manager to do, I need more information about the portfolio.
Do you have the percentage holdings at the level of individual stocks?
I would expect that the evolution of the VaR during 2007 and 2008 as correlations began to converge would have sent off serious warning signals, but I would have to simulate the portfolio at stock level to demonstrate that.
Cheers,
Richard

Pugvestor said...

I'm not familiar with the European banks, but my guess is that the mega banks had loosened their standards and became undercapitalized compared to the risks they were holding. The results, earnings, and stock valuations all looked great during the good times, but with the benefit of hindsight we all know what happened when things turned sour. The four European banks in the portfolio might have looked like the best value in terms of price / earnings, but were actually the riskiest as well.

It's hard to see a crash before it happens and most investors were blindsided by the financial crisis, but I think many would have at least been uneasy with the portfolio concentration in banks (46%!). The portfolio manager might be okay with large drawdowns because he or she understands their strategy and investments, but many clients aren't as forgiving despite what they might say.

Anonymous said...

No diversification by size? These are mostly large cap companies if I am remembering correctly.

Also, it appears this portifolio doesn't have a lot of fixed income assets.

Anonymous said...

In terms of the banks, they seem to be overexposed to those now classified as systemically important financial institutions (SIFI's). And furthermore, a high concentration to those considered as globally systemically important banks (GSIB's).

macro2micro said...

Hi John,

I am not too sure that the portfolio is that bad given a few things.

1. If generally 80% of your success is selecting the correct asset class to invest in (80% SAA, 10 industry 10% picking the "correct" stocks or something like that) then they may had chosen these stocks (when did they actually buy them 2003/2004 etc) when they were "cheap". So up until 2007, they were looking good.

2. So what was the performance up to date? If as you say, they were "revered", then it is unlikely anyone was going to challenge their asset allocation - Who would say to Buffet/Einhorn/Berkowitz et al, that you think their asset allocation is too heavily weighted to some sectors? Or "Gee the market looks a little exuberant at the moment"?

3. As they say, when crashes happen, (like '07), everything correlates to 1. So it didnt really matter what sector or for what reason you were in it, it simply got smashed - there was nowhere to hide.

4. Many value investors, I have read about are the "bottom-up" type. I think that is an incorrect (and a tad arrogant) position to hold. It is simply saying herd behaviour doesn't count so long as "my" stocks are good companies and I can access cash in the future for investment. Whilst some can remain rational, doesn't mean that the whole market can - As Keynes said.......

5. And of course that old chestnut - plain bad luck.

regards
Steve

Edge said...

The portfolio's underlying businesses appear very cyclical. In addition leverage was high in banks and perhaps in some other businesses too. I would try to create stresses and estimate the impact on equity.

Banks - Create stress for loan portfolios and assess the impact on equity.

Other businesses, find EBITDA under stressed situations and value the business using stressed multiple to find the resulting impact on equity.

This will be a subjective exercise so work with a range of stressed values.

Anonymous said...

I tend to think one of 7 things blow up a fund - illiquidity, concentration, correlation, over-priced assets, fraud, debt and capital flight - normally its a combination of them

some issues - 46% of the fund is in financials which are highly geared and rely on open credit markets [sound like the ASX200?] .. suspect these banks also relied on wholesale credit markets a lot?? When your geared 30X you don't have much equity buffer which means too much risk of permanent loss of capital - which is what happened I suspect

A lot of exposure to the consumer - Banks, Beer and Media - these are pretty reliant on a decent economy and likely to underperform in a recession

The portfolio has a fair exposure to disruption with 47% combined in semi-conductor, media and semi-conductor equipment

In a crisis correlations tend to go to 1 which makes things hard

Could have had more industry diversity to hedge [ie healthcare] but not a lot can save a portfolio in a credit crisis

Also he was running 111% net .. I'd prefer to see a much lower net exposure

was he short Volkswagen .. ha!

TheOddLot said...


- 46% of the portfolio is in banking stocks from one country or another. Buffett has previously cited a cap on the % of BRK's net worth he'd put in banks as a whole.

- This concentration also seems to fail Taleb's idea of anti-fragility. Even if they weren't all zeroes, holding such positions still might have severely impaired the managers ability to benefit from any downturn (seen or unforeseen).

- Even the most ardent bottom-up stock-picker perhaps should have a broad level understanding of the sustainability of some macro factors, e.g. global private debt levels (i.e. the other side of burgeoning bank balance sheets).

- The leverage inherent in banks coupled with the leverage of some of the media firms in the portfolio fail your earlier test of 'when to double-down'. This 'test' itself is also related to the concept of anti-fragility conveyed above. I don't think it's good to put yourself in a position where you'd be unwilling to double down on (at least) 46% of the stocks you already own in any environment.

Anonymous said...

Looks like a portfolio built with a value screen!
Given financials leverage it poses serious risk of permanent loss of capital - the key investment risk
Given bank leverage always a chance you get taken out completely
Most hedge funds could not replicate the portfolio - too much industry risk


Kenneth Andersen said...

46% exposure to Banks is quite a lot, but seems exposure to Japan and currency risk USD/YEN is very high if it's not hedged. The same for USD/EUR.

viennacapitalist said...

2 points
* The diversification effect from spreading the bank exposure over different continents is non existent, given hat these are mostly global banks competing in the same marketplace (Eurodollar) for marginal business. Probably a correlation analysis of earnings or even stock prices would have shown that. Hence you get a 50 percent industry concentration in an industry that is very sensitive to the credit cycle.
* I suspect the reason why this manager loved banks so much at the time, is because they had low PE ratios and high ROEs implying undervaluation. However, these were peak Earnings (you could have seen that at the time) driven by historically high leverage (itself driven by historically low regulatory burden) and cýclically low default rates. Low default rates mainly beeing the result of double digit loan growth. Normalizing these earnings would have made the sector appear much less attractive. Apart from the fact that it is almost impossible to get a grip on the accounting of these complex banks with any degree of confidence...

Anonymous said...

Firstly - way too much exposure to banks (46% of the total). Does not matter if they are internationally spread around or not. Thats just asking for hurt if more than a single country is affected as per GFC.

Technology / IC / Semiconductor not such a big deal, those will take a belt in a downturn but provided they survive the long term prospects are probably OK. I work in technology and those companies are OK but well know for having expensive products. I would have picked different and probably done better.

Beer: Well huh, unlikely to lose hugely badly, but also unlikely in the long run to do really well. At least should be fairly stable in the event lots of things turn bad.

Media + Other: Hmmm, no real comment, likely to be fairly stable or do OK over the long term but fair to expect some short term gyrations, esp. for example during the GFC.

Oh, and it looks to be geared. Is that really a good idea? When the banks fall and want their money back you had 46% of the portfolio invested in... banks.... Doh! That really does not seem a great move. If it was 10% in banks it might not hurt so much but imagine all those banks falling like a stone, wanting their money back and the security is their own shares. Talk about a facepalm.

Risk assessment: Even if they are individually good value buys, there is way too much in single sectors when you ignore geography. A big hit could wipe off 20% - 45% of the portfolio value before even considering the knock-on effects (how many of those other companies are geared up?)

Harry Lime said...

I am working with the benefit of hindsight of course... but as a rule of thumb I try not be too exposed to complex businesses/ industries. And in 2008 was becoming apparent that banking belonged to that category. also, back than it was becoming apparent that banks might not have been managed in a optimal wy (to say the least :-) )
So a concentrated bet of almost 50% of your assets in banking at the time seems very risky to me.


The rest of the portfolio seems ok, I mean big tech, beer and media/telcos are relatively safe bets with resilient businesses.

But, once again, that's me talking with the benefit of hindsight. :-) :-)

Phil said...

This portfolio is nearly 50% invested in banks, which have notoriously opaque balance sheets.

The collapse of financial bubbles is notoriously path dependent - which institutions survive and which die can simply be a result of the order in which individual institutions default on their obligations, which is completely unpredictable ex ante. Some investment manager with a portfolio skewed towards the banks was going to be unlucky - are we just picking on the unlucky one here?

Johnny Summers said...

Firstly, thank you for this series of thought-provoking posts.
Regarding this value investor’s portfolio, (and trying to purge hindsight from one’s thinking), I would imagine a risk manager or analyst might like to sit the manager down in the proverbial quiet room, and ask just exactly what was the macro and micro rationale behind making these big sector bets. A question that should be asked irrespective of market conditions, and trying to strip out the prognostications and prejudices of the interviewer. Perhaps the manager had a track record of betting big and it worked gloriously in the past, i.e. performance itself gave the impression of him/her being ‘good’. Perhaps the risk manager might have needed some sturdy cojones to point out to our star that the factor risks were considerable.
‘Value’ scares me; unless tied to good companies, or some catalysts, it means little. The pursuit of the cheapest (aaarghh…the p/e ratio!...the scourge of the well-intentioned), is far, far from a recipe for success. The use of gearing in a fund scares me too. It would be interesting to know if gearing had been a part of the fund’s strategy historically.
Granted that just about any kind of short ultimately worked going through the GFC, but it would be intriguing to find out what the shorts were, and what was the rationale behind their appearance in the portfolio. Same or different m.o.?
As for the ‘tell’, I assume you mean in the poker sense. Hmm…wondering about the giveaway here, but there is collectively enough going on to provoke some pre-denouement enquiry.

Ross said...

I am not based in USA or Europe so that that familiar with these stocks, other than by name, but as a value investor seeking compounding dividend growth, I would say that this portfolio would be terrible for three reasons:
1.Almost 50% in banks. I do not know the particulars, but I view all banks as fairly high risk due to leverage. There is always a chance your investment go's to zero. I would not sleep well at night having 50% in banks.
2.High percentage in tech/media: I like businesses where change is slow and you can predict earnings. Eg. Macdonalds/Coke/Unilever/Diageo. I have no idea what Ebay will be like in 10 years for example.
3. Buying on margin - more risk on top of the bank risk. Personally do not like shorting stocks either, but do not know what was shorted.

Only thing I liked was the beer stocks, as I said I like consumer stocks provided they bought at the right price.

Have enjoyed the last three articles, thanks.

Regards,
Ross

Anonymous said...

Just spit-balling here:
- Preponderance of banks? Incl. William Hill as a proxy for alt. financial services.
- Underestimation of the outsize influence of the U.S. on global banking system?
- Heavy exposure to U.S., Japan (Nippon, Asahi), and Belgium (Group Mondelo cum InBev)?
- Relationship between semiconductor equipment, media company capital spending on infrastructure, and bank lending to finance these projects.

Anonymous said...

John, I think this is a lot like your post on the time the horse bit you. It's the risks you do repeatedly that get you in the end. Things that seem like low risk that you do every day, eventually, they get you.

Would you agree these posts are similar in a way?

Unknown said...

IRRC these are all large cap companies? So this portfolio isn't diversified by size.

Also, this portfolio doesn't have a lot of fixed income assets.

Rahul Deodhar said...

Putting myself in Mar 2008,

#) I would give some weight to when and at what price these were acquired.

#) Too much focus on banks, particularly when Subprime was at its peak. I remember back in 2007 Dec capital cushions were being examined in detail. Banking problems were already anticipated in March 2008. If not going short, at least they shouldn’t be long to this extent. I would not fault him for holding JP Morgan but BoA was problematic. EU banks were particularly capital short. Northern Rock had just happened.

Oracle was too much exposed to finance. But I would buy back Oracle once it was hit.

Japanese banks were in decline since 2005 or so. Can't hold them.

#) March 2008 was too late to be holding media companies. Their time was up. Mostly paying dividend from low cost debt.

#) Traditional retail was also in trouble by then. Ebay may be depending on the entry price.

#) Beer part looks the best of the lot to hold. This is the group I would be comfortable with.

#) Barring Oracle. I don’t know the other tech companies that well. So I would not own them in Mar 2008.

In hindsight, Maxim seems to be ok hoping that he got it at the bottom. Some scaling may come with rise in manufactured devices for automation. The problem with these two companies is that they don’t seem to be talking a lot about their patents and Intellectual property. The profitability comes from IP and long tail effects. Both are absent from these two companies. That is worrisome.

The semiconductor cos seem ok at first brush. Applied Materials, KLA tencor, (testing co) and Novellus all seem to pass smell test. But I don’t have reference point to compare.


No clue about William Hill

This seems to be shitty portfolio. Apart from beer nothing looks interesting from March 2008 point of view.

Anonymous said...

My two Cents,

Having worked for a short period as an analyst evaluating funds for Investing by endowments during that tumultuous period and that too very early in my career and has to move out of it for obvious reasons.We did invest with a few value managers and distressed funds at that time as things were unfolding and we were expecting to find some bargains in a few sectors.

If we were looking at this portfolio ex-ante, based on our process at that time 46% combined to a single sector is very high exposure for a value investor. We do not consider it out of place if it were by a sector specialized fund or if the 24% investment was in a single stock by a value or an activist investor who often hold as few as 8-10 stocks or as high as 20-30 stocks, their risk exposure and risk characteristics with big draw downs are different but provide diversification benefits with good returns for our overall portfolio.

Our questions would be : Cheap stocks are abundant in a sector when either it is depressed or undergoing some change, What IS IT? Depressed or Change. If depressed where in the cycle are we> As catalysts and duration of each industry cycle time varies. If it is change then such high exposure was a red flag to US.

Grant said...

Hi John,
First of all thanks for the blog; I enjoy it "bigly" as Mr Trump says.

It’s an interesting conundrum one that isn’t conducive to quick answer but here goes. With my manager picking hat on, I would be questioning whether this really is a value investor’s portfolio. Such a strong sector bet in banks smacks of trying to juice up your beta.

With my PM hat on, I’d try to explicitly define my key drivers for each stock and ensure they are not overly correlated, because then your clients are better off in a macro fund. One could estimate these drivers quantitatively with a relative simple Arbitrage Price Model or historic scenario analysis. Also, risk management needs to be discussed. Many value investors are buy and hold, but a stop loss, or some futures hedging, may allow one to mitigate a fund killer event.

Anonymous said...

Well, as nobody else commented....

To state the obvious, it's a portfolio with a contrarian view - Financials, Japan and semi-conductors and a flamboyant disregard for portfolio diversification to emphasise the point. In other words, a 6 or out slog sweep (with all fielders back on the boundary).

These sectors are also tough to understand (maybe more of a switch hit - technically harder than a straight drive). This might be the biggest issue for me as I would find it hard to reach such a strong view in these industries.

I also cannot imagine how the March 08 return sensitivities for credible operating scenarios would be so strongly skewed to the upside (say >10% IRR) to justify such concentration. Any sensible analysis (in early 2008) would allow for a high probability of a sharp recession in which case a lot of the potential scenarios would look pretty bad for these companies on a 1-3 year view.

I have a lot of sympathy for portfolio concentration, but I can't see how it would be justified with these stocks at this time or putting so many of them in the same correlated sector. For me this portfolio would fail on the first principle that the potential return scenarios for the individual stocks are too poor before even getting to the diversification, volatility and correlation of the investments. The latter would temper the financial and semi-conductor exposure a bit (maybe Japan is within tolerance).

And for what its worth - if the manager was claiming to be super smart (rather than investors assuming this) that's a sell signal right there.

TheDrugsDon'tWork said...

OK, I'm guessing. Was there a tendency to buy companies that perform acquisitions in partnership. So for example, ABN ABRO was owned by both Fortis and RBS. This created coupling(connected party issues). So when Fortis could not pay RBS, RBS went down. Because ING and Lloyds are Dutch and British respective and both Central Banks intervened it probably signed the death knell for them.

Basically, they perform big transactions that introduce maturity mismatch ballooning their balance sheet - so the shares look like value stocks most of the time but for short periods massively levered, whilst they digest their acquisitions.

I wouldn't have done well in the Stanford Marshmallow experiment.

Denis Brassard said...

It needed more beer investment...

Sean said...

I am an ASX-only investor so I have zero familiarity with the companies above - so the only thing I can see is the portfolio weightings (which possibly makes it easier). What jumps out at me straight away is 48% of the portfolio is invested in the banking industry. Not just one bank either, but multiple ones in the same markets. Even with warning signs that may or may not have been there in 2008, surely that's too much concentration of risk in one sector.

Anonymous said...

I suspect that the European banks disaster arose from reliance on screens. Banks are hard to analyze from the outside given the terrible public reporting, multiple lines of business, and high degree of management discretion in reporting quarterly results. Towards the end of a boom, the banks that are riding for a fall will screen better, because they aren't putting up reserves at the same rate as their more cautious peers, aren't hedging, are still writing as many loans as possible, etc. On the other hand, the banks that are doing the right things will look like slow growers that have been left behind by their more nimble and aggressive competitors. And the whole sector will look cheap by comparison to other industries.

Of course, bank earnings aren't like earnings in other sectors, because no other sector is levered 30-1 and can easily flip to negative margins on its major lines of business. We all know now, it was always true, and it seems obvious in hindsight. Anyone who has studied history knows that a large chunk of the banks periodically go bust. But how would knowing have been a useful thing to a professional value investor during the period from the 1990s until 2008? Guy who is nervous about the risk of the banks in our portfolio and thinks we should go short everything was a very unpopular guy for almost 20 years, and anyone who listened to him lost money. Imagine being the guy who develops an encyclopedic knowledge of lending standards and knows which banks will take the biggest hit if California housing prices crash in 2002. Totally useless! Probably fired!

Sean DiTullio said...

Found this post interesting but out of my knowledge base.

What do you think of valeant now? Seems like they have 2 years of runway now. I've looked at $50 calls for January 2019. They are under $1. That would imply an equity value of 17-18 billion. Being that they are highly leveraged with 30 billion in debt if something goes right that seems like a cheap risks/reward. With a mkt cap of $5 billion and debt of 30 billion the debt is basically the equity. As a vol of vol play looks interesting.

fadewid said...

great post! there's no such thing as managing risk if you are a "value investor" the guy is 50% banks for crying out loud.

a good investment doesn't care what happens to the price of the investment if it is a good investment. again refer to buffett.

fadewid said...

here's what "managing risk" means if you are an investor: you sell on the way down because you're getting out of losing positions and buy on the way up? silly

Unknown said...

Speakimg as a former Portfolio Construction analyst, it's actually not that difficult. Assuming the PM wanted to outperform the MSCI World, we would build a simple variance covariance risk model, which would highlight the contribution to tracking error for every individual security. By March '08 the financials would have dominated that, and the PM would have to justify his position. Non factor risk would also be evident.

Using a (now) standard software package which the fund manager should have had access to (such as Bloomberg PORT or Sungard), the portfolio could be stress tested for various shocks which would highlight other variables (FX, leverage etc).

Bobba Fett said...

Besides the obvious over concentration in banks, my first thought was: "why own 20% in beer and so much in banks? Why not just bet even bigger on banks and stop kidding yourself that the 'defensive' beer stocks would protect you in the event of a downturn?" This is a generally all or nothing fund. Another question though is, are the bank concentrations because of decades of capital appreciation (thus more forgivable, slightly) or recent allocation? At least to me the odd pairings were the "tell" on trouble (and of course the 40% in banks).

Michael Moody said...

You did specify that the portfolio is from a value investor. Value investors are supposed to buy things that are really cheap. All the banking exposure definitely qualifies--but, of course, in retrospect turned out to be value traps. (Funds that my firm was running had no financial exposure and still had 50ish% drawdowns in 2008.) In short, the manager did what they said they were going to do.

Every sector got hit hard, but some recovered. Banks did not. Effective leverage across the portfolio is an issue, as is the sector concentration. On the other hand, some value investors say they will run non-diversified portfolios--and do. It also looks like the investor was trying to get significant dividend yields.

This kind of blowup is just one of the hazards of value investing. I would say that probably nothing is wrong with the portfolio itself. The problem is simply risk management. At what point do you decide you were wrong or that your names are being swamped by macro and that you need to cut exposure?

Mark T said...

Looking back as much as I can (obviously some bust or taken over) it strikes me that by the beginning of 2008 (and in some cases much earlier), every single name was already displaying significant negative price momentum and was trading below its long term moving average. This guy was not unlucky, he was systematically betting that the market was wrong about his whole portfolio.

The Banker's Banker said...

A lot of people suggest having +40% in banks was the real risk. Probably right.

What is the ASX weighting to financials?

Anonymous said...

Now I ain't no financier, and neither is Stone Cold Steve Austin, but there's too much goddamn finance here!

https://2.bp.blogspot.com/-NHKF6vWSycQ/VujEgWCmbhI/AAAAAAAAjvU/6Crh40HRczM05dWwjIg8oa_kgKVul1CvQ/s400/Steveweisers.jpg

Dmitry Kaganovich said...

Random thoughts on the systemic error here:

Commercial banking is, on general, not a particularry profitable business. Nor there is sme explosive upside potential. We're suppose to like commercial banks not for that, but for the relative stability.

Investment banking, however, is both profitable, and has an upside potential. With the benefit of hindsight we know it comes with the adequate downside potential too, but honestly, pre-08 that wasn't the motto of the day.

Hence, many more or less traditional big banks delving deeper and deeper into investment and advanced trading businesses. For the upside ("and we're still cushioned by our core commercial business")
This portfolio seem to have followed exactly the same logic.
Picking banks with more "upside", e.g. more exposure to capital markets and it's operations.
Those are the same that got hit the hardest when it collapsed.

As you missed the whole slew of both particular and systemic risks of subprime, and following that the whole cap market bubble, but see well enough the upside of these operations, this portfolio looks perfect. As anything with giant advantage and disadvantage looks when you're blind to the latter.

Best regards,
Dmitry.

Anonymous said...

Really not sure what the mystery is here. As many have mentioned,

1) overexposure to single sector
2) That sector is banking which is as opaque as you can get

The fact that this fund manager is smarter than me is the tell that he is not a suitable custodian of my equity. Too much emphasis is placed on being smart in the fund management industry.

I know I am not smart enough to understand the make up of any bank's balance sheet so I will rarely if ever invest in them. However, I do know that banking is cyclical and globally interconnected. Therefore, I know that concentrating a large portion of my portfolio in banks is a dumb idea regardless of how much I understand on a micro level.

Investing is a form of gambling. Accepting this makes you realise that what you don't and can never know is much more significant than what you know or can hope to know. I would choose the fund manager that exhibits humility over the smart one every day of the week. Unfortunately, there aren't many of them because humility doesn't sell.

Anonymous said...

As a general rule if you are going to concentrate your portfolio, you should do it in stocks that you feel comfortable owning for the long-term. In other words, there should be an element of quality in what you chose to invest in.

By quality I mean high probability of average-to-good returns. In other words, the asymmetry between the upside and the downside doesn't need to be as wide because the downside isn't as big and the upside is hopefully more reliable.

You end up beating the market by holding - i.e. you reduce taxes and trading costs and you capture the compounding effect of reinvestment of retained earnings.

If you want to chase long shots then you need a different portfolio. For starters you want the asymmetry between upside and downside to be very wide, at least 4 or 5 times to 1. You don't need to own a lot of something if it has this kind of payoff profile for it to make a big difference.

So you want lots of small bets that are as different from each other (uncorrelated) as possible. If you can't find lots of bets then you should have a decent allocation to cash. After all the cash drag will not hurt your performance too much if a few of your 5-1 bets pay off.

Such a large allocation to financials goes against this principle.

Anonymous said...

The statement:
The four European banks here (Lloyds, RBS, Fortis, ING) however received capital injections so large that they were effectively nationalized.

... is actually incorrect. ING received government support via a loan scheme (fully repaid last year iirc).

You may be mixing up ING with ABN Amro.

By March 2008 it was clear RBS and Fortis were joined at the hips (they were part of the consortium that took over ABN Amro) and thus it would be an error to see them a entities with different destinies, especially because the ABN Amro acquisition was very costly and fraught with resistance/contention.

Cheers,

FM

Anonymous said...

highly correlated returns across the entire portfolio...hindsight aside, it doesn't take an FRM to see that a catalytic event would blow up the portfolio.

Mike Hamm said...

The David Dreman portfolio -

The 'E' in P/E's weren't real.

Everyone here talks about too much concentration in banks - but what if he had only 30%? 20%? Aren't value investors meant to concentrate their bets?

His biggest error was his highest concentration was based on a valuation and error in judgement.

If he used Greenblatt's method of trying to 'normalise earnings' with low multiples then he would have had less bank exposures.

Trader Joe said...

1) Almost half the portfolio in financials 2) Leverage upon 30-1 leverage 3) And I would know what the 12% Other component is and how correlative/additive it is to 1) and 2)

Anonymous said...

Assuming the portfolio was managed relative to an index (e.g. MSCI World), a competent risk manager could immediately have shown that the ex-ante tracking error was focused in one sector and a few stocks.

Stress testing, VaR analysis (the banking sector under performance was well under way) and factoral attributions through a system such as Sungard or PORT would have revealed all.

This Portfolio Manager had only his own arrogance/naivety to blame!

Michael said...


I believe the banks were levered between 10 and 30 times going into 2008 so looking at the positions by the cash invested strikes me as looking at a futures portfolio by only looking at the margin requirements.

I think the portfolio holdings should be rewritten with the debt and asset components of the underlying companies broken out. The return on assets of this portfolio would look terrible, assuming net assets of banks was around 10% the true net exposure is more like 300%, and doing the analysis monthly would show the portfolio exposure growing as bank asset values fell from mid-2007. I am not very familiar with those banks but I expect if they failed that by Mar 2008 their ratios and the rate of change of the ratios of assets to debt was looking much worse than their peers.

I think this sort of analysis in equity portfolios has become pretty standard with maturing of private equity strategies. As in this paper - https://www.google.com.au/url?sa=t&rct=j&q=&esrc=s&source=web&cd=9&cad=rja&uact=8&ved=0ahUKEwiiwtLEwfDRAhUEppQKHa-IA50QFghVMAg&url=https%3A%2F%2Fwww.quantopian.com%2Fposts%2Freplicating-private-equity-returns-with-leveraged-small-value-stocks&usg=AFQjCNGfwkNt9eDtDHHuRxRaJ-AgVBKc9g&sig2=sZBBB_HNMlgrAdW08_PxtQ&bvm=bv.146073913,d.dGo

Anonymous said...

Hi! Do you invest in biotech? Im now looking at GILD and its pretty good seems. But not stockpicker, interesting Pro opinion therefore :))

Markus Rezny said...

Several issues with this book:

The concentration in financials is even at the best of of times (i.e. a recovery/reflation trade) extreme. Banks and insurance companies are too opaque to lend themselves for analysis from the outside (and often bank's own boards do not grasp the true exposure in their book. Banks are just an option and the thinnest wedge in a particular macro outcome. Having read plenty of sell side analysis and worked with very smart buy side analysts and PMs formed this view.

Second, given the leveraged nature of banks' equity (and the high beta of many of other holdings), the true net long exposure of this book was probably more like +/- 200% net long. The financial crisis was just icing on the cake.

Third, the guy a bias to pick poor management and corporate governance: it was well known that management at e.g. Fortis, ING, RBS, BofA, Nomura, but that also extends to e.g. Oracle, Budweiser or Heineken. Particularly in an un-analysable sector such as banking, management quality is paramount. Poor management was evidenced among others by expensive/dilutive/risky M&A (e.g. ABN Amro).

Forth, I would question the reason for the 20% exposure in brewing. If this exposure was taken to add a defensive component to the book, clearly the gross and net exposure of the rest of this highly cyclical book needed to be cut aggressively. But I am assuming that this was a consolidation game.

Fifth, this is was aggressive positioning at a time when equity markets were expensive. Measures with highly predictive power such as mcap/GDP did show that. So it was a classic mistake of buying poor quality securities towards the top of an economic/equity cycle.

Best, Markus

Strategic Investor said...

The 46% of the portfolio invested in banks was uniquely concentrated, as the primary counterparties / transactions of those companies are each other. This is really a unique industry feature. It is simply not true in say industrial companies. The big final assembly brands do not sell much to each other or own a claim on assets of each other, so if one goes down, it tends to create opportunity for the other players.

In banking, in contrast, most of the assets and transactions ARE with other banks, so if one goes down, it blows a hole in the balance sheet of the others. So by owning 7 or 8 different large cap banks, the portfolio manager effectively has one big undiversified position. (Interesting though exercise / paradox: had he bought just *1* big bank, he might have had less risk. By owning so many, he nearly guaranteed that there would be a run on his holdings. Had he found one that was relatively less exposed, Wells, perhaps, or even BAC (prior to the Countrywide acquisition, which alas, happened, so there was that) he might have had less overall credit cycle risk than he actually took by diversifying.

All of the rest of the companies just about had pretty large credit cycle exposures. Media has traditionally been pretty stable, but not so much in the last 15 years, and a major downturn in credit was going to hit advertising.

Given the lateness of the credit cycle, I am surprised he did not have more downside protection - puts or index futures. These would have had roll-cost, admittedly, but if he went well out of the money, it might have been manageable. Interest costs were pretty high then, though, so there was that.

In all, this was a momentum portfolio. There is nothing really defensive (consumer staples anyone?) at a time when the market was clearly struggling, he was rear-view mirroring. Banks looked super cheap as securitization allowed them to generate fees out of all proportion to their balance sheets. That was risky and someone working in the industry should have known as much.

Anonymous said...

Looks like the TCI portfolio.
He lost 40% and made it all back.
He took the view that, as he was the largest investor in his own fund, he was aligned.
He also knew that the Fund was not the only vehicle in which his clients were invested. They understood that they had to provide their own diversification.
His long term performance vindicates the approach.

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