Monday, December 6, 2021

PWA Year-End Letter: Part 1, Smart-Investing Metaphors

As has become our custom in recent years, we'll devote the beginning of our 2021 year-end message to a metaphorical look at how we view what we do.  

This year’s final message will come to you in parts. Again, part one will focus on how we here at PWA metaphorically view the investing process. In Part 2 we'll go right to what we view as the setups that presently matter most.

But first (as in previous Part 1s) we'll list what we believe to be the essential characteristics of the world’s best portfolio managers -- the traits we everyday strive to embody:
1. A passion for macro economics and market history.

2. A firm understanding of intermarket relationships.

3. A firm grasp of global macro and geopolitical developments.

4. An obsessively strong work ethic.

5. The ability to transcend his/her ego and political preferences.

6. A willingness to buck prevailing market trends (diverge from the crowd) when the risk/reward setup inspires it.

7. An understanding of and appreciation for the uncertainty of markets.

8. A flexible and open mind.

9. Utter humility.
Having been intimately involved in financial markets for the past 37 years, and being a fisherman at heart (observant of flows, weather patterns, water (liquidity) levels, temperature, obstacles, and so on), I tend to find investing metaphors virtually everywhere I look.

Every once in a while one of those metaphors turns into an analogy, which turns into a narrative during client meetings, which ultimately turns into a blog post.

Here we'll have a little fun with two that describe how we view the very serious work we do:

Measuring the Ice

So, you’re going ice skating on a popular lake, and I happen to be the guide you’ve hired to instruct you and to show you a good time.

As you approach the lake you find me waiting, and you see a huge crowd of folks having the times of their lives; cutting, sliding, skidding, kids romping all over the ice.

We have a seat, you lace up your blades, you rise up and I say "stand still a minute, we're not quite ready." 

I then proceed to strap onto you a life vest with a pulley on its back, through which I thread a rope then toss it over the thick limb of a nearby tree.

You say to me, "Marty, what the heck are you doing? If I even get onto the ice before dark I'm not going to have much fun the way you've got me all bound up!"

I say to you, "Well, you know, I got here early so I could measure the thickness of the ice and take the outside temperature.

And, unfortunately, while I understand how it looks on the surface, with all those folks having such a great time, I checked my notes from my own personal experience (been taking folks out onto the ice for 37 years), as well as my studies of literally centuries of related history, and, well, virtually every time the ice was this thin and the weather was this warm the ice ultimately broke. And, sadly, many of the skaters who were out there completely unprotected sank to the bottom, some never recovered.

Now, I honestly can't know for sure if the ice is going to break this time as well, but I do know that the risk is high that it will. And, frankly, I'm just not willing to take you out there completely unprotected.

Not that we won’t enjoy our time on the ice, but as long as it remains this thin we’ll do so with a layer or two of protection against drowning.

Of course, if/when a big freeze hits and the ice thickens back up, I'll happily release the binds and we'll have ourselves a ball."

I love skating fast on thick ice when the odds suggest that our falls won't do us severe long-term harm -- which, in our view, is essentially not the case today...

The ice of course represents financial market conditions, and the rambunctious skaters represent the average investor who never measures the ice (like this unfortunate fella),

and the student/customer represents our clients' portfolios...

Said protection typically consists of complementary asset classes that are uncorrelated to stocks, as well as strategically designed, and sized, options hedging strategies...

Four Types of Investments

I play a lot of basketball, 
and, as my son and the dudes I play with will attest, I like to attempt three-pointers.

In that success enhances the enjoyment of virtually any endeavor, I knew from the start (my late start [not surpassing the 5'5" mark till after high school and, thus, being a wrestler during my formative years]) that if I was to score enough to justify my itchy trigger finger, I had to learn good shooting fundamentals.

While I'm fully aware that 100% from the field is infinitely beyond my reach, I know that if I can stay in rhythm, if my form is sound and if I practice good shot selection, my odds of maintaining a respectable enough percentage to keep me from being the lowly last pick come time to select the teams increase dramatically.

Different players bring different talents to the game. There's a young man we play with, we'll call him Bartholomew (just in case he happens to stumble upon this blog post) who possesses exceptional ball-handling ability and plays the point beautifully.

Surprisingly, however, his outside shooting leaves much to be desired. So much so that when he launches a three his teammates cringe; hoping the ball finds nothing but air.

Now why would his own teammates want Bart to miss his shot, in embarrassing fashion no less? Because they know that if he drains it, their odds of winning will decrease exponentially.

You see, Bart believes that a shot that goes in has to be a good shot. Therefore, when he makes one he believes that he suddenly possesses the fundamental makings of a good shooter -- and good shooters shoot. So he shoots and he shoots and he shoots and, in reality not having mastered good shooting fundamentals, he misses and he misses and he misses and, alas, his team loses.

We can sum up basketball shooting as follows. There are:

1. Good shots that go in.

2. Good shots that miss.

3. Bad shots that miss.

4. Bad shots that go in.

#1's are great.

#2's are fine, unavoidable, and possess a livable probability rate.

#3's, while costly, are the most predictable and, therefore -- being costly -- should be readily avoided.

#4's, as explained above, are an utter curse!

Here's my point:

We can sum up investing in precisely the same fashion. There are:

1. Good investments that make money.

2. Good investments that lose money.

3. Bad investments that lose money. 

4. Bad investments that make money.

#1's are great.

#2's are fine, unavoidable, and possess a livable probability rate.

#3's, while costly, are the most predictable and, therefore -- being costly -- should be readily avoided.

#4s: I can't think of a worst-case scenario than a new investor hitting a #4 right out of the gate. The perverse feedback from that experience could absolutely send him/her to the poorhouse -- as he/she might think that he/she's discovered a high probability investing method and chalk up the subsequent string of losses to rotten luck. I.e., believing what are in reality #3s to be #2s. The emotional imprint from that early "success" may indeed last longer than his or her capital. 

Our ultimate goal as a firm is to do the deep macro and micro work that has us only making what we believe to be fundamentally good investments on behalf of our clients’ portfolios...

Well, folks, the easy part’s over… The rest of our letter, coming to you in sections over the next few weeks, will take us deep into the market/economic weeds.

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