James Montier: “Finance Has Turned The Art Of Transforming The Simple Into The Perplexing Into An Industry”The Acquirer's Multiple
Some years ago James Montier wrote a great paper called – Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt. Montier’s states that we can learn a great deal about investing by looking back at the mistakes that gave rise to the worst period in markets since the Great Depression saying:
“It appears as if the market declines of 2008 and early 2009 are being treated as nothing more than a bad dream, as if the investment industry has gone right back to business as usual. This extreme brevity of financial memory is breathtaking. Surely, we should attempt to look back and learn something from the mistakes that gave rise to the worst period in markets since the Great Depression. In an effort to engage in exactly this kind of learning experience, I have put together my list of the top ten lessons we seem to have failed to learn. So let’s dive in!”
Klarman 2017 letter on
- the danger of Chinese leverage
- Discipline while value investing in bubby times
- Value investing is not dead
- Radicalization of politics
- Dangerous FAANG valuations
Here is a list of Montier’s ten lessons:
Lesson 1: Markets aren’t efficient
Lesson 2: Relative performance is a dangerous game
Lesson 3: The time is never different
Lesson 4: Valuation matters
Lesson 5: Wait for the fat pitch
Lesson 6: Sentiment matters
Lesson 7: Leverage can’t make a bad investment good, but it can make a good investment bad!
Lesson 8: Over-quantification hides real risk
Lesson 9: Macro matters
Lesson 10: Look for sources of cheap insurance
While all of these lessons are very important, for the purpose of this article we’ll focus on Lesson 8:
Over-Quantification Hides Real Risk.
Here is an excerpt from that paper:
Finance has turned the art of transforming the simple into the perplexing into an industry. Nowhere (at least outside of academia) is overly complex structure and elegant (but not robust) mathematics so beloved. The reason for this obsession with needless complexity is clear: it is far easier to charge higher fees for things that sound complex. Two of my investing heroes were cognizant of the dangers posed by elegant mathematics. Ben Graham wrote:
Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw there from … Whenever calculus is brought in, or higher algebra, you could take it as a warning that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.
I can’t imagine a better description of recent times: the rise of the Gaussian copula, which “enabled” the pricing of such delights as CDOs, correlation trading, etc.
Keynes was also mindful of the potential pitfalls involved in over-quantification. He argued “With a free hand to choose co-efficients and time lag, one can, with enough industry, always cook a formula to fit moderately well a limited range of past facts … I think it all hocus – but everyone else is greatly impressed, it seems, by such a mess of unintelligible figures.”
In general, critical thinking is an underappreciated asset in the world of investment. As George Santayana observed, “Scepticism is the chastity of the intellect, and it is shameful to surrender it too soon or to the first comer: there is nobility in preserving it coolly and proudly.” Scepticism is one of the key traits that many of the best investors seem to share. They ask themselves, “Why should I own this investment?” This is a different default from the average Homo Ovinus, who asks, “Why shouldn’t I own this investment?” In effect, investors should consider themselves to be in the rejection game.
Investment ideas shouldn’t be accepted automatically, but rather we should seek to pull them apart. In effect, investors would be well-served if they lived by the Royal Society’s motto: Nullius in Verba (for which a loose modern translation would be, “Take no one’s word for it.”).
One prime area for scepticism (subjected to repeated attack in this note) is risk. Hand in hand with the march toward over-quantification goes the obsession with a very narrow definition of risk. In a depressing parody of the “build it and they will come” mentality, the risk management industry seems to believe “measure it, and it must be useful.” In investing, all too often risk is equated with volatility. This is nonsense. Risk isn’t volatility, it is the permanent loss of capital. Volatility creates opportunity. As Keynes noted, “It is largely fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”
We would be far better off if we abandoned our obsession with measurement in favor of understanding a trinity of risks. From an investment point of view, there are three main paths to the permanent loss of capital: valuation risk (buying an overvalued asset), business risk (fundamental problems), and financing risk (leverage). By understanding these three elements, we should get a much better understanding of the true nature of risk.
You can read the entire paper here.
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Article by Johnny Hopkins, The Acquirer's Multiple