Here is a gem I found on a link to a January 2011 Bloomberg article I had missed. “U.S. Treasuries are among the most overvalued assets and investors buying them are poised to lose money,” Montier was quoted as saying. He goes on, “You are not compensated for the long-term risk of holding bonds.”  If you love Montier or behavioral finance, check it out.

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Montier quotes Keynes in his opening, “central principle of investment is to go contrary to general opinion, on the grounds that, if everyone is agreed about its merits, the investment is inevitably too dear and therefore unattractive.” Tail  risk is a nebulous concept that must be defined. He settles on the notion of “systemic illiquidity.”

Montier defines three general types of tail risk protection.

1. Cash- He states that it, “is perhaps the oldest, easiest, and most underrated source of tail risk protection.”

2. Options/Contingent claims- the example of this he gives is credit default swaps on mortgage backed securities, when the times were good and few people thought they needed them.

3. Strategies that are negatively correlated with tail risk- for systemic illquidity long volatility strategies are negatively correlated.

He sums up this section by stating that tail risk protection requires timing and substantial levels of investment to work.

At that point Montier turns to a value investing approach to guarding against tail risk. He states that “is the only risk-averse way of investing that I know of. It comes with ready-made framework for assessing (tail) risk.” He has defined risk as the permanment impairment of capital, that can be broken down in three ways.

1. Valuation Risk- this is the risk of paying too much for an investment, buying something that is overvalued. He re-emphasizes the value of cash as a tail risk protection. It is better to “better to hold cash and deal with the limited real erosion of capital caused by inflation, rather than hold overvalued assets and run the risk of the permanent impairment of capital.” Montier argues that Bernanke would prefer we hold overvalued assets. Buffett has said, “holding cash is uncomfortable, but not as uncomfortable as doing something stupid.”

2. Fundamental Risk- when we ponder Fundamental risk it helps us define exactly which fat tail risks we are really worried about. Graham said the “danger of a loss of quality and earnings power through economic changes or deterioration in management,” is what fundamental risk is. Again Montier highlights the value of cash as a hedge. It is good against deflation and better than bonds against inflation.  He suggests that most “Financial implosions” are the result not of Black Swans, but of “predictable surprises.” This is a term coined by Michael Watkins and Max Bazeman. predictable surprises have three characteristics. 1)at least some people are award of the problem, 2) the problem gets worse over time and 3) eventually the problem explodes into a crisis.

3. Financial Risk- this is risk of leverage and crowded trades. You can easily avoid leverage and being a contrarian, Montier says,  reduces the risk of being in an over crowded trade.

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I have meant to post on  James Montier’s concept of investing risk ever since I first read Montiers writings. He gets risk in a way that the uber-smart quants sometimes fail at. He recognizes that risk is not an equation or number, it is a concept.  Much of this post refers to his Clear and Present Danger; The Trinity of Risk, but I will refer to other of his writings as well. You really should read Montier directly.

For anyone who follows in the Graham school of investing, or this blog, you know that first and foremost is preservation of capital. Montier begins in this tradition,  “Graham saw risk as the Permanent loss of capital.” Amen. We as investor’s often spend way too much time chasing the return and not examining the downside. That is the risk.

Montier divides investing risk into what he calls the trinity.

The first aspect of this trinity is valuation risk. Simply stated the risk that you will screw up the valuation of a company and over pay for the stock. Montier says, “buying expensive stocks leaves you vulnerable to disappointment.”This is classic value investing. Don’t overpay. There are lots of metrics to keep things cheap.

Montier suggests that we should return to works of Graham and make sure we are not buying a stock with a P/E greater than 16. He quotes Graham, “We would suggest that about 16 times is as high a price as can be paid in an investment purchase of a common stock? Although this rule is of necessity arbitrary in its nature, it is not entirely so. Investment presupposes demonstrable value, and the typical common stock’s value can be demonstrated only by means of an established, i.e. an average, earnings power. But it is difficult to see how average earnings of less than 6% upon the market price could ever be considered as vindicating that price.”

The second aspect of the trinity is business/earnings risk.

Again Montier defines the term by quoting Graham, “Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.” When a company suffers an earnings drop, or an outright loss the price of the stock can drop substantially.

The trick in assessing Earnings risk, is to figure out whether or not an earnings set back is temporary or permanent. If you get this wrong you will end up with a value trap instead of a good deal. Again Montier has a metric. Instead of just looking at Price Earnings alone, he suggests that you look at the ratio of P/E to the ten year average P/E. To minimize earnings risk this ratio should be less than two, perhaps considerably.

The third of three is Balance Sheet/Financial Risk. Montier again uses Graham to define, “The purpose of balance-sheet analysis is to detect? the presence of financial weakness that may detract from the investment merit of an issue.” According to Montier most investors are smitten with earnings and only look at balance sheet risk when something goes awry. Obviously, with the emphasis on NCAV stocks on this, we often start with balance sheet risk.

Montier uses a metric that readers of this blog will recognize, the Altman Z score. Interestingly, he uses the standard manufacturing equation in his evalution, but I will tweak Montier, if I may, and refer to the non-manfuacturing Z-score.

T1- Working Capital/Total Assets

T2- Retained Earnings/ Total Assets

T3- Earnings before Interest and Taxes (EBIT)/ Total Assets

T4- Market Value of Equity/Book Value of Total Liabilities

T5- Sales/Total Assets

The revised Altman Z score is Z= 6.56T1+3.26T2+6.72T3+1.05T4

The score should be above 2.6 for non-manufacturing, non financial companies to minimize balance sheet risk. If it is below 1.8 watch out. For manufacturing companies refer to the original Altman Z score.

Now you can put all this together. But ultimately, Montier sums up best when he argues  “that risk is really a notion or a concept not a number. Indeed the use of pseudoscience in risk management has long been a rant of “(his).

Look at a range of factors that make up investment risk and take appropriate action.

What do you think comprises investment risk. Am I missing anything?

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I think he gets investment risk better than any one. I will quote two passages, the first lays it out, “Modern risk management is a farce; it is pseudoscience of the worst kind. The idea that the risk of an investment, or indeed, a portfolio of investments can be reduced to a single number is utter madness. In essence, the problem with risk management is that is assumes that volatility equals risk. Nothing could be further from the truth.”

The second is where he talks about his trinty of risk which I would like to devote a whole post to in the near future, “…I don’t think of risk as a number, but rather as a permanent impairment of capital (as Ben Graham put it). Now that permanent impairment can be generated by three potential sources (which aren’t mutually exclusive). Firstly, there is valuation risk – you can simply overpay for an asset. Secondly, there is fundamental or business risk – something goes wrong with the underlying economics of the asset. Thirdly, financing risk or leverage (which no matter how hard you try can’t make a bad investment good, but can make a good investment bad).

I’m not sure that any of them is easier or trickier to monitor. I think you to consider all three aspects in order to gain a holistic view.”

Enjoy the first part of the interview.

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As a basis for today’s post, I will highlight some points that James Montier made in an article titled, Process Not Outcome in Gambling, Sports and Investment!, that I read in his Postcards from the Edge.

“Psychologists have long documented a tendency known as outcome bias. That is the habit of judging a decision differently depending upon its outcome,” says Montier. He sets out a chart that breaks down the results from Process and outcome that looks like this:

For obvious reasons we would all like every decision to be in the upper left, that is Good Process, Good Outcome, because it yields a Deserved Success. But we won’t. Sometimes we venture into the territory of the bottom left. Dumb Luck. And given the outcome bias we will want to reinterpret the decision making process because the result was good. However, Montier says, that if you can’t make this distinction, “the bad process will continue and the good outcome that occurred once will elude you in the future.”

Let me step back to Parker’s comment again, “It is very possible to make an investment that is fully rational, fits your portfolio, has a high expected return, and still loses money due to factors outside of your control. On the flip side, it is also possible to make money playing Lotto or engaging in other irrational activities.” I would argue that the outcome bias is so strong that we often confuse the two ideas of process and outcome, we certainly do in the film business.

In fact holding people accountable for outcomes, according to a meta study conducted by Lerner and Tetlock, has some undesirable characteristics, including:

“i) increase ambiguity aversion (increased preference for alternatives with less ambiguity
despite equal risk).
ii) increase the collection and use of all information (both useful and useless).
iii) increase the preference for compromise options, and increase the selection of products
with average features on all measures over a product with mixed features (i.e. average on four
traits, preferred to good on two and bad on two).
iv) increase the degree of loss aversion.”

Montier sums up, “During periods of underperformance … the pressure always builds to change your process. However, a sound process is capable of generating poor results, just
as a bad process can generate good results.”

But how can we be clear that the decision was sound and that the outcome was unfortunate result in such a case? I think one needs to hold tight to principles that have worked over time, and that have evidence that supports the success of these methods. Much has been documented in the Value Investing world about out-performance over time of buying low price to book small cap stocks and Net Net Stocks discounted by Graham’s Margin of Safety of 33%. That is a good place to start developing a strategy.

But it is also important to put a frame around your decisions. Assuming you are following Value Investing Principles that have worked, how long do you hold a loser? How long before you admit that the result was poor, even though the decision may have been good?

As I often do, I will return to Graham. He discussed a time frame for investments being an appreciation of 50% ( if the decision results in a good outcome) or to sell it in two years, no matter what, (if the decision results in a less favorable outcome). That is certainly a good place to start. Most investors don’t have the patience these days. The average investor holds a stock just 9 months right now. Two years may seem like an eternity to realize a return on capital. But evidence also bears this out. That these kinds of investments can take time to realize a return.

Do you have any thoughts on this subject? Is there a better way of determining if you have outcome bias? Or is there a better way of determing how long to hold unprofitable stocks? If so please post in the comments or email me at chroma at chromainvesting dot com.

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Ultimately, Montier delivers a prescription “towards a better way of Investing.”

He sums it up like this:

• Focus on Maximum real return after tax
• Value, Value, Value
• Be Contrarian
• Be Patient
• Be Unconstrained
• Don’t Forecast
• Cycles matters
• History Matters
• Be Skeptical
• Be Top Down and Bottom up
• Treat your clients as you (sic)

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