IBM: "I’ve Been Manipulated"?

 IBM, to IBMers, always stood for “I’ve Been Moved,” a reference to the way Big Blue moved employees around the country and around the globe to get experience as they worked their way up the ranks.

 To Wall Street, however, IBM could stand for “I’ve Been Manipulated,” because no public company we can think of does a better job of schmoozing Wall Street’s Finest and convincing them that there’s a there there, when in fact the there is not quite as there as it might seem.
 The quarterly earnings calls are curiously synthetic, almost antiseptic affairs, run by the CFO and focused strictly on the numbers: on the revenue number, on the cash flow number, on the share buyback number, and on the earnings number.  
 In particular, the per share earnings number.
 The CEO never graces the call, and no actual business operators discuss their business.  No success stories are told, no customers highlighted.  It is all about margins and currencies and so-called one-time charges and so-called one-time gains, and tax rates, and how all those things added up to the earnings per share that quarter.
 And, most especially, what that earnings per share means forThe EPS Roadmap.

 But let’s back up a bit…

 In May 2007 IBM held an analyst meeting to introduce a “2010 Earnings Per Share Roadmap,” to “give our shareholders a clear understanding of the key factors driving IBM’s long-term financial objectives.”

 Those objectives were EPS growth of 14-16% and EPS of $10-$11 by 2010.

 To get there the company spelled out five “Key Drivers” of the Roadmap: revenue growth, margin expansion, share repurchases, acquisitions and retirement-related savings.

 And certainly IBM got there: in the 2010 annual report, IBM could proudly state that EPS had come in at $11.52—above the high end of the “Roadmap” range.

 And Wall Street loves companies that beat the high end of anything.

 Now, it is true that the “revenue growth” piece of the Roadmap didn’t play out as perhaps many had expected: 2010 revenues were only 1% above 2007, the year the Roadmap was laid out. 

 But the margin expansion and cost savings played out in spades: from that $1 billion in extra annual revenue sprang added gross profits, added operating profits, and added net income of $ 4 billion each, give or take (mostly give).  

 Meanwhile, ample share repurchases acted like gasoline on the fire, juicing EPS almost 60% on that tiny 1% revenue gain.

 So well did the 2010 “Roadmap” go over with shareholders and Wall Street alike, that IBM rolled out another: the 2015 Roadmap, comprising, in this order, “$8 billion of productivity improvement” (e.g. layoffs and reorgs); $50 billion in share repurchases and $20 billion in dividends; and “four growth priorities” that included emerging markets hitting 30% of revenue in 2015, business analytics (e.g. Watson, the Jeopardy champ) hitting $16 billion of revenue in 2015, cloud computing hitting $7 billion of revenue in 2015, and what IBM calls “building a smarter planet”—what everyone else calls “the internet of everything”—hitting $10 billion of revenue in 2015.

 The bottom line of all this?  $20 in earnings per share by 2015.

 But that target came with an asterisk, literally:

 The asterisk mentioned that the $20 target was a so-called “non-GAAP” EPS target, which “excludes acquisition-related and non-operating retirement-related charges.” 

 As we pointed out many times in these virtual pages during the many occasions we poked fun at Hewlett-Packard before that company, as a friend likes to say, hit the trees with no flaps down, “non-GAAP” means earnings not prepared in accordance with generally accepted accounting principles.  

 IBM’s 2010 “Roadmap” had come with no such asterisk.

 Nevertheless, IBM’s recently retired CFO, a key driver behind both “Roadmaps,” always said the $20 EPS target was “all-in,” i.e. while it included gains on sales of things, it also included losses on charges of things.

 Fortunately—and quite remarkably, the casual observer might think—those gains and charges on things at times almost exactlyoffset each other.

 In the first quarter of 2009, the company had a $265 million “workforce rebalancing charge” offset by a $298 million gain on an asset sale.

 And in the first quarter of 2010, another “workforce rebalancing charge”—this time $560 million—was paired with another one-time gain of $591 million.

 Neat, right?

 So adept has IBM been at matching the cost of downsizing its operations with gains on sales of bits of those operations that it was apparently hoping to generate a big enough gain from the sale of its server business to offset the $1 billion “workforce rebalancing charge” it took in 2013 (these charges are one of the bigger growth items in IBM’s P&L)—but Lenovo appeared to play hardball and the sale didn’t happen in 2013.  Meanwhile, a different, smaller sale (at a reported measly 5-times EBITA), of a service business to Synnex, didn’t close in time to help the 2013 EPS.

 Nevertheless, IBM today proudly announced that it had “delivered” fourth quarter EPS of $6.13 a share, “up 14% year-to-year” to bring the full 2013 EPS to $16.28, magically in line with Wall Street’s Finest, and right down the middle of the all-important Roadmap.

 How it got there, though, was way more complicated.

 After all, revenue dropped 5% (down 3% adjusted for currency).  Asia-Pacific revenue was down 6%.  China revenue was down 23%.  Pretax income dropped 8%.  Pretax margins were likewise down.  Free cash flow was down 13% in the quarter and 21% for the year.

 Yes, you read that correctly: free cash flow was down 21% for the year.

 Oh, and the company guided first quarter 2014 EPS to something around $2.50 a share versus Wall Street expectations of $3.27 a share—a 24% miss.

 How, then, did IBM show “up 14% year-to-year” profits in Q4 2013?  
 And how did the new IBM CFO manage to re-affirm the all-important, almighty $20 EPS Roadmap?

 Well, with a mere 11.2% tax rate, all targets are possible, profitability-wise. 

 “But wait a minute,” the reasonably informed observer might ask. “What is really going on here?   Economies are recovering around the world.   Europe had a near-death experience two years ago and is healing.  China is growing nearly 8%, not shrinking 23%.  American industry is recovering broadly.  Our banks are healthier than they have been in a decade.  State budgets have revived and governments are spending again. 

 “So why the punk revenues at one of the largest, most important purveyors of IT equipment, software and services in that very same world? 

 “And why are 'workforce rebalancing charges' growing from $440 million in 2011 to $803 million in 2012 to $1 billion in 2013, even as US unemployment drops and companies from Google to Amazon to eBay to Apple to Facebook to Salesforce can’t hire engineers fast enough?”

 Well, IBM blames hardware, but IBM’s software revenues were only up “3% to 4%,” and that includes acquisitions: the “all-in” approach taken by the CFO means that, unlike most companies playing the non-GAAP game, IBM does not provide organic, non-acquisition-inflated revenues.  That is 3-4% growth, inflated by acquisitions, in a world where Salesforce.com is growing 35% a year organically, and Amazon Web Services is growing…don’t ask.   
 Meanwhile, the rest of IBM’s business, a mix of consulting and outsourcing, has been fair-to-middling-to-poor.

 The reality, we think—never stated on an IBM call, because the discussion never veers from the numbers, but fairly obvious all the same it would seem—is that much of IBM’s business is tied to the “higher value, more profitable technologies,” touted in the IBM annual report as the areas towards which the company has been shifting its business mix over the years (think: helping a company install expensive SAP software on big-iron IBM hardware with white-shoe IBM consultants running the show, all financed by IBM) while shedding the stuff Wall Street did not care for (even its baby, the disk drive business, which IBM invented).

 And that kind of high cost IT infrastructure business is yesterday’s glory.  (Just ask Avon Products, which we will get to in a bit.)

 Of course, if you are an IBM shareholder, it has been a great ride.   After all, pretty much everything the company has been doing, like the song says, it has been doing for you.

 Here, for example, is how last year’s letter to IBM shareholders began:

via:http://jeffmatthewsisnotmakingthisup.blogspot.in/2014/01/ibm-ive-been-manipulated.html

IBM 39, Emerson Electric 2

Quick!  What’s wrong with this paragraph?

 Good day, ladies and gentlemen. Thank you for standing by. Welcome to Emerson's investor conference call…. This conference is being recorded today, February 4, 2014. Emerson's commentary and responses to your questions may contain forward-looking statements including the Company's outlook for the remainder of the year. Information on factors that could cause actual results to vary materially from those discussed today is available at Emerson's most recent annual report on Form 10-K as filed with the SEC. I would now like to turn the conference over to our host, Patrick Fitzgerald, Director of Investor Relations at Emerson. Go ahead. 

 If you said, “Golly, it doesn’t include the usual warnings about how the call ‘contains non-GAAP financial measures’,” then you win.

 Emerson, you see, doesn’t lead with non-GAAP financials the way some companies do—and by “some companies” we’re thinking especially about IBM, which uses non-GAAP financials the way a magician uses his sleeves.

 “We present GAAP numbers,” says Emerson’s famously frank CEO, David Farr.  “Which means we include all pension costs, all intangible amortization, and our performance share stock programs in the consolidated numbers.   We present GAAP numbers.”

 And Farr is true to his word: All the numbers Emerson’s team discusses on its calls are strictly GAAP—that is, they conform to generally accepted accounting principles. 

 In fact, in Emerson’s press release yesterday, the term “non-GAAP” appeared just twice, at the very end of the release with a table detailing a modest GAAP to non-GAAP reconciliation that would have boosted year over year earnings growth from 5% to 8% had the company chosen to use it.

 Emerson did not, however, choose to use it.

 IBM, on the other hand, has no such qualms.  

 The term “non-GAAP” appeared 39 times in IBM’s most recent quarterly earnings release, starting in the very first sentence.

 Such is IBM’s prowess at presenting the most favorable numbers possible that, as we have seen in our previous look at the number-massaging machine known as Big Blue, an 11% pre-tax income drop in the fourth quarter turned into an 11% after-tax gain, thanks to the magic of a near-non-existent 11.2% tax rate in this year’s quarter.

 Now, you may wonder how Warren Buffett, who routinely complains about the big-shots in America who pay a lower tax rate than his secretary, feels about that.

 We don’t.  After all, Buffett also complains about the big-shots who don’t pay big inheritance taxes on their wealth, yet Buffett will avoid the biggest inheritance tax bill in American history by giving away his shares in Berkshire Hathaway ahead of time, and rationalizes it thusly: he’s just following the rules.

 Surely IBM is just following the rules.

 But what rules, exactly, is IBM following?

 Fortunately, Bloomberg has the answer, here, in a story that broke yesterday around the time Emerson’s clean, all-GAAP earnings were hitting the tape.  

 Seems IBM routes “almost all sales in Europe, the Middle East, Africa, Asia and some of the Americas” through a Netherlands subsidiary, IBM International Group BV, which counted 205,000 employees at the end of 2012, “only 2% of whom actually work in the Netherlands.”

 The Dutch Connection, according to Bloomberg, helped IBM shave $1.8 billion of its expected tax provision in 2013—adding more than 10% to the $16.5 billion in net income IBM reported.

 And that, it appears, is how what might have been a 10% decline in net income for the full year became a modest, easily massaged 1% drop.

 Which is why, as we’ve seen, unlike Emerson Electric—which plays it straight down the middle—IBM prefers to focus Wall Street on its non-GAAP, AGWICTMTQGP (“Anything-Goes-When-It-Comes-To-Making-The-Quarter-Accounting-Principles”) number, where the weeds are deeper and the ball can be moved around without too many people noticing.

 The problem with non-GAAP, AGWICTMTQGP-based earnings reports, as we pointed out many times when Hewlett-Packard was popular with the beat-the-quarter crowd, is that it allows companies to include the good stuff from, say, acquisitions (revenues and gross profits) while excluding the bad stuff (intangibles and employee severance costs).

 And as HP found out this week when it years-too-late revised Autonomy’s 2010 revenues down by precisely 54%, the good stuff isn’t necessarily as good as it appears to be at the time.

 As for how all this bears on IBM’s set-in-stone $20 EPS “Roadmap” for 2015, we have no opinion except that IBM will make it.

 There may be 39 uses of the phrase “non-GAAP” in the press release announcing that $20 number, but they’ll make it.

 How can we be so confident?   Well, the recently-announced sale of the IBM server business to Lenovo for starters. 

 Lenovo is paying IBM a couple billion for a business that has a negative book value.   So IBM will have, we are told by Wall Street’s Finest, a gain of $1 billion for the non-GAAP, AGWICTMTQGP cookie jar.

 Even with the SEC investigating how IBM reports its “cloud” revenue (disclosed last year)—IBM juices up its “cloud” revenue by including hardware and IT services in the number—we would bet they make it.

 In fact, we put the odds at, oh, 39 to 2.

via:http://jeffmatthewsisnotmakingthisup.blogspot.in/2014/02/ibm-39-emerson-electric-2.html

Best hedge fund

Best hedge fund? Recently visited the offices of the best ever hedge fund. Client needs mean I must do ongoing due diligence at the world's greatest SKILL BASED managers. I don't bother with MARKET DEPENDENT funds. Too risky and unsuitable for institutions and individuals with long term investment goals.

Money is too important to be risked on "the market". I am comfortable allocating to highly skilled humans that can make money REGARDLESS OF MARKET DIRECTION. Though rare, such skill can be detected with proper analysis. For asset classes, history is not forward looking. Asset allocators bet on horses and lose years of gains in bear markets. I bet on jockeys, not horses, as I wish to always avoid major meltdowns. How about YOU?

Skill persists but luck runs out. When does PAST performance indicate FUTURE returns? How to find a "top fund"? Fame? Invest with good managers BEFORE they are famous. Despite outstanding performance, George Soros, Warren Buffett and Jim Simons were unknown to the media and general public for decades. The best managers of the future are ignored today but if you work hard enough you can find them.

Below is the chart of a wildly popular fund I analyzed a while back. The fund is open and you can, if interested, invest in it. "Experts" like Eugene Fama, David Swensen and Burton Malkiel say it's great. I think it's terrible but I have to preserve client capital, unlike them. The "gurus" urge speculation on unskilled passive funds but the endowments that pay them favor skill, like I do. Jack Bogle thinks retirees, widows and orphans should gamble on naive stock and bond benchmarks no matter how expensive or how far they could fall!



Seems good. A +20% CAGR after fees for ten positive years. The returns have been independently audited many times. It's transparent, heavily regulated and available to all investors. No leverage, lockup or valuation issues. The manager keeps it simple by investing long only in liquid equities on the highest market value stock exchange. No arcane assets, crazy CDOs, malicious models, specious SPACs or dubious derivatives so it must be good?

After analysis I concluded the fund was too risky despite being recommended by rearview mirror loving "Nobel" prize winners. I decided to figure out who was the best manager ever. The criteria for a good fund are complex but necessary to find the best. If we define the top fund as that which achieved the highest risk-adjusted returns over several decades, the wealth accumulated by the manager from his trading acumen, the consistency and repeatability of performance from protectable edges then the best ever hedge fund manager is obvious.

The “god of the markets”, Munehisa Honma, ran a managed futures CTA hedge fund in the 18th century. His fund performed outstandingly for over 50 years. His main writing, "The Fountain of Gold", is the best "how to invest" book ever written. His trading ability enabled his family office to become the largest land owner in Japan. They later diversified into the Honma golf business which makes sense if you own vast tracts of flat land in a mountainous region. A set of Honma clubs has "high" fees but like hedge funds versus index funds, you get what you pay for in superior results. Destroy your golf score with "cheap" clubs? Wreck your portfolio with 0.2 for passive trash or grow and preserve wealth by paying 2 and 20 for skill?

Munehisa Honma's net worth was over US$100 billion in today's money. Some years he "took home" more than the equivalent of US$10 billion so it's curious why pundits are excited about the "news" that John Paulson received "record" pay of just $3.7 billion. Fair "salary" for the over $12 billion he generated for clients that they would not OTHERWISE have. Like Honma, Paulson's hedged client portfolios. REAL hedge fund managers focus on achieving returns to monetize their talent and build wealth. Shorting subprime was NOT the greatest trade ever. Good but not greatest. "Ever" means since 2002? Recency bias yet again. Honma's short sale of rice futures in 1789 was far more profitable than Paulson's "big" credit short.

There's a fountain in the main garden of Honma's house as a reminder of the source of wealth. As befits many successful hedge fund managers, Honma was an avid art collector. He also advised the world's first sovereign wealth fund. Though rice was heavily traded and analyzed in those days, such liquidity did NOT produce an efficient market. He figured if he worked hard to develop competitive informational and analytical advantages he could extract alpha out of other traders, regardless of whether futures brokers themselves were bullish or bearish or prices were rising or falling. That's a TRUE hedge fund. Any firm needing a bull market to make money is NOT a hedge fund.

Note for the long only luddites: the GREATEST trades tend to be shorts. Hedge fund "pioneer" Alfred Winslow Jones did not "invent" hedge funds. He invented the term but not the philosophy. Munehisa Honma was investing for absolute returns two centuries earlier. By 1755 Honma already knew that psychology and the IRRATIONAL actions of participants NOT economic logic drove markets. Behavioral finance isn't new, it's 253 years old. He didn't buy and hold rice and wait to be compensated for its higher risk. He did not "expect" a risk premium or "assume" that rice prices would rise over time. Index fans regard those as axiomatic for "stocks". Neither equities nor credit carry a risk premium. Trade them but NEVER hold them. 

Munehisa Honma paved the way for the hedge fund managers of today. Translated adages from his main book - "Market action is more important than news". "Prices do not reflect actual value". "Buys and sells are decided on emotion not logic". He discovered the truth all that time ago and without the computers, analytics and communication systems we have. He also knew the dangers of transparency: "Never tell others your positions or strategies". His performance speaks for itself. They should retrospectively award him one of those "Nobel" prizes that economists still hold onto as they continue their futile search for a rational market.

Honma wrote of the returns to be made buying when most are selling and shorting when everyone else is buying. Consult the market about the market! Even today many spend valuable time on Fed watching when they could INSTEAD be seeing what the MARKET is saying. The Market told us we were entering a recession several months ago and the credit crisis was NOT "contained". The Market is not efficient but it forecasts better than any economist. As befits the samurai trader he was, the time between making a decision and implementing that decision must be minimized. Delayed execution and transparency are the enemies of performance.

Though primarily a statistical trader, Honma also spent time on fundamental analysis, talking to farmers and consumers about what moved rice prices, who was buying or selling and why. He had detailed historical weather data and analyzed it to predict a key factor driving rice yields. His strategies required low latency trading so, despite the pre-electronic era, he established a signaling system all the way from Sakata to the Dojima Exchange in Osaka to get orders done and price data as quickly as possible. He developed many quantitative techniques to maintain his competitive advantage; some simple ones, like candlestick analysis, have entered the public domain but other more sophisticated methods he rightly kept to himself.

Honma invented black box algorithmic trading. As his impact on the markets grew he evolved from market-taker to market-maker. He leveraged his informational advantages and adapted to the situation as needed. Those quants who download a decade of security prices and then overoptimize and curve-fit to the patterns of recent history might remind themselves that Honma analyzed 1,500 years of rice data BEFORE doing a trade. He focused on finding robust and persistent phenomena NOT spurious patterns containing zero PREDICTIVE information.

Feedback fuels future fluctuations. Honma would have scorned those economists that assert that markets have no memory. Securities are traded by humans and computers programmed by humans, both of whom DO have memory. If the input has memory then the output has memory. If no memory is assumed, prices might indeed follow a random walk. "Nobel" Prize "winner" Paul Samuelson supposedly "proved" that "Properly anticipated prices fluctuate randomly" which might have been relevant except for the INCONVENIENT TRUTH that prices are NEVER properly anticipated.

Stock, bond, currency, real estate and commodities prices are determined by participants with memory, so prices themselves also have memory. Honma accumulated more wealth exploiting security price memory than all the economists TOGETHER who have ever believed in memoryless markets. Not only is there NO efficiently priced security; it is impossible for an efficient market to exist. Amnesiac assets? Absurd. Rational agents? Really. The future state has no dependence on the present or past states? Preposterous.

Many trading techniques can be traced back to Honma. It is interesting how often Western investors get caught out trying to trade Japan. Some fixed-income arbitrage hedge funds got hurt by cash Japanese bonds recently. The yen carry trade has damaged many that didn't realise that a low interest rate does NOT imply a weak currency. As Honma wrote, the cheap can get MUCH cheaper.

Some might be skeptical of technical analysis and know nothing about Japanese-style technical analysis. Fair enough. There are plenty of fundamental ways to make money. But if a bigger investor with a few trillion yen to put to work believes in such things as candlesticks, Kagi, Renko, Heikin Ashi and Ichimoku then that may impact the markets and lose money for those who do not master such methods. If you don't know your edge then you don't have an edge but that edge must be enough to overcome other traders' edges. I haven't come across ANYONE able to consistently make money trading yen, JGBs or Japan equities without a thorough understanding of Japanese analytics.

I didn't trade any security in Japan until I knew ALL the above methods cold. Incredibly many rookies still try (and fail dismally) to trade Japan profitably. As Honma knew and John Maynard Keynes implied, the key is working out what others will do and how they value securities NOT one's own estimate. The market may NEVER value an asset "correctly" as some activist and value investors in Japan have recently found out to their cost.

Honma was the first successful quantitative trader. Isaac Newton's earlier trading forays weren't successful but then gravitational modeling is easier than financial modeling. The sun WILL rise tomorrow but the motion of the markets is less predictable. It is interesting how today more scientific method and new math are being applied to the markets. But OLD math and dubious economic "theory" have not coped well with modeling REALITY. Assets classes affect each other but the ways they interact change over time. Since no traded security moves randomly, the math of randomness is not useful in finance. Today many still use it because stochastic calculus is easy, unlike the quant methods that work.

ALL assets are connected. Honma monitored many things even if they had no apparent connection to rice prices. Everything is related and NOTHING is independent. Beware of ANY financial "model" that assumes independent, identically distributed prices. We have seen the dire results though it does allow alpha to be transported from those that use them to those who employ better methods to win the zero-sum game. The Central Limit Theorem has no applicability to the REAL statistical distribution of prices.

Japanese electronics, washing machines and subway systems make use of fuzzy logic. Fuzzy logic is disdained by those who think we live in an orderly, bivalent world of true/false, right/wrong, yes/no and 0/1. I once developed a fuzzy model to calibrate the bullishness or bearishness of the Japanese market. It provided nice projections for the daily ranges for the JGB, Nikkei and yen. Given the inappropriate Ito stochastic integral for pricing derivatives, I also adapted the Sugeno fuzzy integral to derive a more accurate option replication and hedging model. Isn't the world itself FUZZY so fuzzy logic could be of use? The market is vague even at the best of times. The market is NEVER in a 1 or 0, bull or bear state; it is always somewhere between 0 and 1.

Japan therefore had the world's best ever hedge fund - Honma's long/short rice fund managed from the 1740s to the 1790s. The chart above is a Japan "passive" index fund performance from 1980-1989 but below is the ENTIRE performance chart since 1980. Past perfomance was not indicative for future performance in any country. The risk and volatility since 1990 have failed to compensate investors with high returns but that would not have surprised Honma. Performance comes from hard work and talent NOT buy and hope. A good heuristic for assessing investment strategies - if it is simple then it won't work. Easy "solutions" cause difficult problems, as we have seen.



Returns have not been good for the TOPIX since the high water mark set so long ago. The 1980s were NOT even the best decade; the 1950s compounded at a 25% CAGR and returned 10X investors' money. Even now, so many years into a bear market, the TOPIX remains the top returning stock index in the post war period. Would I therefore invest in it? Absolutely not. I want funds that WILL perform in the future not rely on a magnificent past. But for those who like "cheap" long only equity funds and historical data dredging, it is interesting they don't overweight Japan. As for me I am staying long yen, long JGBs and short the Nikkei for now.

I prefer the manager risk of TODAY's superstar traders and investors NOT the risk of long only funds. Honma-sensei thrived in volatile market conditions. Recession will make the absolute returns generated by top hedge fund managers important and they have the best ever, Munehisa Honma, also known as Sokyu Homma (本間宗久) and born Kosaku Kato, for inspiration.

Since Honma's era there have been many obituaries written for the hedge fund industry. We are on another iteration right now because a few beta dependent speculators masquerading as hedge funds recently blew up. That SOME hedge fund strategies are short volatility and can be modeled as effectively short sellers of put options and hoping a black swan won't show up to reveal their fund as a data snooping lemon is very OLD news. 

Ten years ago Long-Term Capital Management short sold options and bet the house on convergence and got taken out by the "never happened before" Russia default. Fortunately there are many quality hedge funds run by managers who are fully aware of the dangers of being short gamma and convexity, potential "rare" event fat-tail risks, carefully hedge for those exposures or maintain a long volatility profile. Sure plenty of "hedge funds" are no good but there are many skilled hedge funds that do manage risk.
via:http://hedgefund.blogspot.in/2008/04/best-hedge-fund.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed:+HedgeFund+(Hedge+Fund)

Fiduciary duty

If you haven't served the mandatory 50,000 hours needed to develop investment skill or don't have time for the 100+ hours per week necessary to stay competent, find someone that has. Consistent success takes rare talent and dedication so most "professionals" and all amateurs must underperform. Don't confuse luck with a bull market or for skill. Why risk ANY MONEY on the unskilled market?

Forget about "investment grade bonds" and focus on finding investment grade fund managers. Unlike "cheap" passive strategies that do no security analysis and buy everything no matter how risky or expensive, I prefer rigorous portfolio construction and manager selection. Fortunately profitable opportunities can be found if you work hard and are good enough. Bond benchmarks are size weighted: don't permit your wealth to be lent to the world's most indebted borrowers.

YOUR money deserves to be invested with the best but talent is rare. Out of the 10,000 "hedge funds" I've looked at and hundreds visited globally that made the first cut, I have found less than 100 worth investing in after due diligence. Industry averages for active long only managers and hedge funds are downward biased by hordes of unskilled. Security and manager selection drive 100% of returns. Asset allocation has little to do with it. Conventional wisdom failed as it didn't hedge risk or control drawdowns.

Risk parity is just jargon for leveraging bonds. At such low yields? Bond prices went up so risk parity made money. If fixed-income goes down they will lose. Investing in SKILL allows investors to meet goals. Avoid "new" spins on old beta. If 60/40 can't deliver required risk adjusted returns why should 60/80 or 60/120? Don't risk poverty on risk parity.

Low volatility equity is just the age-old strategy of buying defensive stocks. Low volatility isn't low risk. Generic copycat strategies and hedge fund wannabes guarantee poor "industry" returns. Less than T-bills after stripping out factor dependencies. "Risk parity" and "low vol" are as bad as prior "solutions" likeportable alpha and 130/30. Remember them?

Smart money invests in skill. Sadly "modern" portfolio theory still has believers and trillions are still bet on "efficient" betas. Gold made absolute returns every year SO FAR this century; as has a carefully constructed, skillfully diversified portfolio of the world's greatest fund managers. Does gold itself have skill or was it the decision to buy gold? As with luck, gold's rise will end but skill marches on. Alpha is much more useful than gold. 

Long term investors must survive many short terms. I'm only interested in managers that work hard, have exceptional focused expertise and are incentivized to deliver consistent absolute returns. If a client asks "Should we invest in China?" I interpret that to mean "Do Chinese markets offer short selling/long opportunities that a highly experienced Mandarin reading and speaking security selection specialist can generate alpha from?" to which the answer is of course YES. Some think it just means "Do we buy China beta?". 

John Bogle claims there is no such thing as skill! Adoring cap-weighted indices, he gambles Mom and Pop's retirement on lists of big companies and most indebted borrowers. But he thinks Jim Simons and Warren Buffett were just lucky. Can you really afford to avoid active expertise and bet on "cheap" passive? Reliable returns take hard work and dedication not naive asset allocation. Special forces always outwit benchmark hugging conscripts over time. Most do-it-yourself investors get as painful results as do-it-yourself dentists. 

Why limit allocation to 0% - 100% range when -100% to +100% is safer? Every QUALITY portfolio manager makes use of short selling. It's IMPOSSIBLE to properly diversify or manage risk without it. Long only is wrong only and only appropriate for speculators. In recent years stocks AND bonds have risen. If they can both go up, they can both go down! Risk parity uses a short history during which bonds mostly only rose. After 30 years with a brief correction in 1994, risk parity is unlikely to be robust to a sustained bond bear market.

Why hope unskilled asset classes might deliver? People want top quality portfolio management and advice not "equity benchmarks (should) be higher if you wait a few decades". Regardless of the economy, we need absolute returns to grow capital or pay liabilities in RELEVANT time frames. Most equities underperform over time and don't compensate for risk while bonds pay insufficient real income for default and inflation. Hire brilliant people to buy good securities and short sell bad ones; limit "the market" effect on your wealth.

Invest in skills not asset classes. Sadly most investors are urged to bet on long term index "performance". Strategy and manager selection are critical for diversification because asset class dependent funds ALWAYS lose in down periods. How to find major league alpha and avoid hordes of beta repackagers in the minor leagues? The market "average" is no place for YOUR money and neither is the "average" fund manager

Everyone has risk budgets, spending policies and retirement liabilities to prepare for. I need absolute returns at low risk not relative returns at high risk. Such fund managers are scarce and don't run beta-based funds. Beta is dependence on an index but alpha is profitably finding securities to short sell or buy. I choose rare funds that can do skilled security selection and manage risk. Index funds ignore risk and do zero security analysis! Such expensive toxic waste is unsuitable for all investors.

Quality absolute return strategies are the solution. It's much easier to become a movie star or sports legend than to be a good fund manager. Beating the market isn't useful and doesn't require skill. Cash has performed better than most developed equity markets over 15 years. Does that mean cash and bonds have alpha? No. Are they worth investing in at current yields? Long only is wrong only.

Risk and return are unconnected. It's no longer a question of whether to invest in alternatives. Alpha is the ability to produce higher returns than the risk taken. Passive pundits say you must have X% in stocks and (100-X)% in bonds for all scenarios changing only as a function of "risk aversion"! If "risk free" bonds yielded 10% perhaps "age in bonds" might have made sense but not at these yields. It's no surprise many investors feel discombobulated.

Most portfolios are overexposed to stock or bond market drawdowns. Ignore asset class labels and focus on the best unconstrained funds. Let them decide the what, where, when and how of making money for you. Identifying them is itself a form of alpha. Anyone managing their own portfolio should compare themselves to the best not the average and make sure their capital is being put to work optimally.

I separate manager returns into market dependence and value added. Most define an index fund as designed to track indices but I broaden it to funds whose returns are mostly driven by underlying benchmarks or factors. In the last three years the MSCI World and HFR Fund Weighted Composite had +0.91 correlation! Most so-called absolute return funds lose money in down markets. Any product whose performance is dominated by a benchmark is more an index fund than a hedge fund. Many "hedge funds" are simply beta repackagers. Typically I can screen out 90% of the universe very quickly.

Of the remaining 10% of managers, I then calculate what percentage of alpha was due to skill and what from luck. I use hidden Markov models to uncover hidden factor dependencies. After further qualitative and quantitative analysis 90% of that 10% is also eliminated. Starting from thousands of funds I end up with less than 10% of the 10%. The cream of the cream of the crop. Those who refer to "hedge funds" as an asset class know NOTHING about hedge funds. Ignore people that say they can't forecast the short term but claim to be able to predict the long term!

1. Buy GOOD funds in drawdowns. All genuine hedge funds lose money sometimes. No matter how brilliant, even the best managers only have small competitive edges. I doubt there is anyone that gets even 60% of investment decisions correct over time which is why great defense is more important than good offense. Every true hedge fund is CERTAIN to have drawdowns. "Hot money" amateurs usually redeem often creating great entry points for new clients. Famous drawdowns include those by Ken Griffin 2008, Jim Simons 1989, Warren Buffett 1974 and Munehisa Honma 1769. Buying into those drawdowns resulted in great wealth. Skill is persistent, luck runs out.

2. Don't avoid proven strategies. Only invest in what you understand? If you don't understand a strategy, find someone that does. Many times I look at the - losing - portfolio of a "diversified" fund of funds and see no black box quant, no managed futures, no short biased, no volatility arbitrage and no frontier markets funds. No surprise such FOHFs are losing assets while the good ones that look at all strategies are thriving. High frequency trading is a reliable source of returns but no institution globally has issued an RFP for a HFT allocation. Yet. A strategy's holding period is irrelevant. For the past 250 years the best performing funds have been quant.

3. Do proper due diligence but don't take too long. Many investors take months and months, often years, to decide whether to invest in a fund. There is no evidence that such a slow process adds any value or avoids incredibly rare frauds. We live in a high frequency world. It takes me a few minutes to decide to avoid or exit a fund. Deciding to invest in a fund takes a few days provided I have visited all its offices and interviewed the most senior and most junior decision-making staff. And if someone I trust is happy with the operational, back office side and I am familiar with the administrator and prime brokers.

4. Never invest in a fund that is often mentioned in the mass media. Ideally you want funds the mainstream has never heard of. It is very hard to produce returns when a manager's every move is followed and scrutinized. Beware of overly transparent funds. Transparency to ACTUAL investors is important but not to anyone else. I have daily position level detail for most invested funds. I receive over a thousand monthly performance letters and commentaries each month but you won't see any here. Secrecy is the edge.

5. Ignore pedigree. Many investors place great emphasis on managers' previous firms or education. Practical experience is important but track records are rarely fungible or relevant. More importantly it is not a predictive indicator. Even more dangerous is paying any attention to universities attended. Common sense is not so common and no-one has a PhD in it. Avoid any fund advised by Nobel prize "winners".

6. Always redeem from funds announcing their intention to IPO. Every hedge fund firm in the world that went public hasn't made a cent for clients since it went public! Serving two CONFLICTING masters - LPs and shareholders - does not work and shareholders haven't been served well either. Check out hedge fund IPO prices and the value today. Price is what IPO buyers paid, value is what shareholders received.

7. Every investment in a hedge fund is venture capital. It makes no difference if it was set up yesterday or 60 years ago like BRKB. People worry a lot about capacity and AUM. Some strategies only have room for $200 million, others $200 billion. A good manager closes his fund long before returns reduce. Never fall for the old "closing soon" trick. Don't believe the "We are closed but for you we are open" nonsense. Beware of the "endowment" effect and holding onto funds past their prime. Every fund has to justify itself every month. Otherwise it's time to upgrade to a better one.

8. Incentives are necessary for a functioning economy and incentives are critical to a successful portfolio. The best managers charge incentive fees. Investing in hedge funds is about replacing market risk with manager risk. Constructing a portfolio of good funds is as difficult as selecting securities so I use similar processes. You need powerful metal detectors to find alpha needles in beta haystacks. Few people have the combination of talent, expertise and work ethic to produce absolute returns in excess of absolute risk on a consistent basis. The FORWARD-LOOKING detection and estimation of alpha is non-trivial.

The great thing about hedge funds is there are always new ones to look at. As great funds close, successful managers retire and unsuccessful ones go out of business, better strategies are developed. Like everything it's a dynamic active selection process unsuitable for policy asset allocation. The average hides funds in the far right tail of the talent distribution. The stock market is a market of stocks. Who lives in a passive world? Who wants average portfolios with average performance? Whether it is trading stocks or choosing funds, the aim is to maximize use of capital and minimize opportunity cost.
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Managed future?

Are you managing your future by hiring skilled people to invest YOUR money? Or hoping unskilled asset allocation gets lucky? Some mathematical models do work. Here's a proprietary equation that has served me for many years: good manager + bad period = buying opportunity. Sadly most investors do the opposite so their dollar weighted returns are poor compared to time weighted returns they should have achieved. I've increased allocations to quality strategies in EXPECTED drawdowns many times. A great alpha source is getting in when dumb money is redeeming. 



Trends end quickly and violently. Do the opposite of the dumb money that buys high and sells low. Since most phenomena are non-linear it stands to reason that linear equations are of no use. The simplest pear-shaped formula is y^2=x^3-x^4 which only has solutions in the real world for inputs between 0 and 1. Remarkably the area under that curve above comes to pi/4. Yet another example of pi showing up unexpectedly. 

We can define the beginning of anything at zero and ending at one to transform any data set into that range. Identifying and jumping onto a trend is relatively easy. Lots of people make money in bull markets. Only the best figure out how to make money in bear markets or when to short sell an ending bull market. 

The crowd has no clue on picking hedge funds. As I wrote in late 2008, most hedge funds went on to perform very well in 2009. Some MADE MONEY both in 2008 and 2009. The media claim 2008 was a bad year but it was actually the greatest year for GOOD hedge funds. Risk management and skill are EVERYTHING. Remember the "experts" who said the hedge fund industry was finished. They are welcome to "cheap" index funds. Most generic fund of hedge funds haven't a clue how to select managers.

Smart investors are increasing allocations to hedge funds. It's no surprise that market dislocations, misvaluations and panic-selling hysteria created fantastic alpha capture opportunities for skilled managers. Performance was certain to be strong when so many "professionals" even recommended to avoid all hedge funds. Bear that in mind next time they offer you more absurd investment "advice". Redemptions by those who didn't understand true diversification benefited investors that REDUCED risk by having more alpha in their portfolios.

All trends end. Inconsistent those who argue trend following has no value but advocate long only equity because of a historical up trend last century that can supposedly be extrapolated into this one. Their insouciant belief in past being prologue is pathetic. The volatility of recent years has shown "difficult" times provide the best risk management stress test.

The more long lasting the trend, the more violent the end. The trend is your friend until it ends. The last two centuries were positive equity markets in some countries so this one will be too? A logic that far too many STILL believe. On a long enough time scale the survival rate of ANYTHING tends to zero. Bear that in mind next time your hear the "value" of buy and hold!

Definition of a trend: “What the wise man does in the beginning, the fool does in the end.” Even more impressive are the hedge funds that made money in both 2008 and 2009. Proper hedging and market timing is difficult but some have the talent. A way to evaluate any investment strategy is its return on risk. Even with the recent stock and credit market rally, the return on risk of long only funds has been terrible. Is the mythical equity risk premium positive or negative? I don't know but unhedged stock market exposure is too unreliable for investors wishing to grow and preserve capital. Invest in managers with the skills to MAKE MONEY when things go pear-shaped - ie markets or economies go bad. 

The potential return from stocks fails to compensate for their notorious risk. Most economists and "passive" index fans sell a rosy view of a DISTANT future that we can apparently all look forward to...eventually. I hope they are right but CONSISTENT CAPITAL GROWTH requires mitigating the downside. Few investors can afford to ignore deep drawdowns or vicious volatility. Follow the trend? Into the abyss? Thousands of equities have dropped to zero but NONE has ever gone to infinity. Portfolios need to be structured for ANY possibility including a dystopian long term. If your portfolio is not stress tested and hedged for a 90% stock market and real estate crash and all "risk free" government bonds defaulting then you have the wrong portfolio.

Unfortunately the crowd STILL uses normal assumptions which is fine UNTIL things cease to be normal. Pear-shaped situations require pear-shaped analysis. I prefer non-linear pear-shaped equations since they capture the initial quasi-linear uptrend and then nicely model the nasty end game. WE DON'T KNOW THE FUTURE but we do know that there are always securities to short sell and others to buy. Linear mathematics is easy which is why too many financial "professionals" rely on it to their clients' heavy cost.

Many things are pear-shaped. The universe is pear-shaped. Time is certainly pear-shaped. Just ask Professor Stephen Hawking. Atoms are too. If the largest and smallest physical systems are pear-shaped, it seems possible that financial structures also exhibit a similar form. Bonds and loans are great assets till the borrower defaults. Mortgage backed securities are fine unless real estate or interest rates go pear-shaped. Bull markets last longer and have low volatility while bear markets (pear markets?) often eviscerate years of growth. Beta climbs the wall of worry and then speedily descends into the dungeon of delusion.

Recently I read some books on the economic shape of the world. One was The 
World is Flat by Thomas Friedman. While interesting, the premise is incomplete. The world is actually pear-shaped and only gives the illusion of flatness during easy times. Protectionism may slow the globalization trend. While David Smick's book The 
World is Curved is more insightful, we need techniques to prepare for the different scenarios beyond the curve. Perhaps I should write a book called The World is Pear-Shaped.

Invention eliminates the obsolete. The life-cycle for businesses shortens all the time. Corporate and even country hegemony is not as long term as it used to be. Typewriters and slide rules had rising sales for decades but have not had much "growth" recently. Innovative investment strategies that seep into the public domain and crowded trades are prone to end with a meltdown. Bubbles take a long time to form but a short time to end. The best alpha generators are those managers equipped to navigate difficult markets. Successful trend followingrequires good entries AND exits.

Some absolute return strategies went pear-shaped in 2008 like CB arbitrage and long biased equity. The returns have stormed back this year by those managers with the skills to achieve them. Meanwhile good managed futures CTAs and short biased funds continue to deliver ESSENTIAL negative correlation to their clients despite experts worrying about their TEMPORARY losses. Fiduciary duty REQUIRES portfolio construction for optimistic AND pessimistic scenarios. Bear markets or bull markets are irrelevant in a robust strategy allocation.
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