It's a Chaotic World. Profit From It.

It's a Chaotic World. Profit From It.

by Michael McGaughy, Beyond Proxy

In my research and investing I stress three things: people, structure and value. I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests and trade at valuations that are below intrinsic levels if not outright cheap.

This post is mostly about people. More specifically it is about investors and their desire for steady returns. While I can understand the desire for predictability, it runs against my experience and philosophy.

Stability definitely has its place. A stable political system, marriage and friendships are extremely good things. And Iā€™m about as far from an anarchist as possible.

But I feel differently about business and investments. In fact I get scared when things are too stable and predictable. The world is wonderfully chaotic and investors should embrace this rather than spending a lot of time, energy and money trying to smooth returns. ā€œEntropy is the only constantā€ is my favorite graffiti.

Let me explain.

In the last few months Iā€™ve been talking to people about my investment process and how I can help manage their funds. Itā€™s been going slow. Most of the world is looking for steady, safe and predictable returns. Asiaā€™s moneyed class are looking for steady returns of 5-6% according to feedback from several in the financial community.

European investors must be even more scared. Many are not only forgoing positive returns, but are paying governments for the privilege of holding their money. Hence the negative government bond yields in many European countries.

In contrast my investment strategy and process ā€“ which looks for out-of-favor quality companies in beaten down markets ā€“ are dependent on continued volatility. Great bargains rarely appear in steady markets. Great returns are also rare in steady markets.

Be Afraid of Stability

Twenty-five years ago as a young analyst I loved analyzing companies that had steadily increasing sales, constant profit margins and growing profits. This made my financial projections easy.

However experience has taught me not to trust steady returns and stability. The business world is competitive and anything but stable. I now believe that ā€˜stableā€™, ā€˜no riskā€™, and ā€˜guaranteed returnā€™ are some of the most frightening words in business and investment.

Consider the following:

  • Bernie Madoffā€™s funds got big by seemingly delivering steady monthly returns in both up and down markets. As we know now, it was all a fraud.
  • Before it went bankrupt, Enron was well-liked by sell-side analysts and investors for meeting analyst estimates. It steadily met expectations and was considered a stable and safe company. But it was mostly smoke and mirrors before it became Americaā€™s largest bankruptcy.
  • The desire for, and fallacy of, steady growth is nothing new. Adam Smith (aka George Goodman) wrote about the illusion of steady growth in his 1972 book SuperMoney. ā€œEverywhere you looked, there was a company with a neat stepladder of growing earnings. Some kept the stepladder right up to the day they filed for bankruptcyā€ (my review of the book is here).
  • In his commentary on Dell being fined by the SEC for fraudulent accounting designed to smooth earnings, author and Darden School of Business professor Edward Hess notes that, ā€œcompanies that grow for more than four consecutive years without resorting to earnings games are the exception, not the ruleā€ (source document is here).

Growth and investments by definition are dependent on the future. No one can predict the future so there is simply no way to fully guarantee their success or return. Not every corporate expansion project works just as not every investment works (ask me about Ukraine. Link here).

At the end of the day, the world is not a stable or predictable place. And we donā€™t want it that way:

  • If the world was stable over the last 100 years most of us would be plowing fields and playing cards instead of working in temperature-controlled offices and surfing 100 cable channels.
  • Who would have predicted that a college dropout, hippy wannabe and a disheveled electronics geek would create Apple which changes the way we communicate, access information, and take pictures?
  • Iā€™m sure Kodak and many other companies would have preferred the stability of the pre-digital world. Investors who embraced change did well, those that stuck with the old did not
  • The biggest advertisement for positive effects of change is China. Virtually the entire country has transformed in the last 30 years. Subsistence agriculture to export manufacturing to domestic consumption. Rural to urban migration. Collective agriculture to private property. Etc, etc

The world is wonderfully chaotic. Live with it. Embrace it. Profit from it.

 

Copyright Ā© Beyond Proxy

Michael McGaughy, CAIA, manages money and consults to asset managers, funds and research organizations through Yuan Asset Management Ltd. (http://www.yuanasset.com). An award winning analyst, Michael has a diverse financial background spanning buy- and sell-side equity research, private-equity fund management, and fund- of-hedge funds management. He first came to Asia as an exchange student in 1985 and has been involved with the region ever since, having lived and worked in Beijing, Hong Kong, and Singapore, for different companies including HSBC, the old Crosby Group and StoneWater Capital.

Total
0
Shares
Previous Article

7 Ways to Bounce Back from Lifeā€™s Inevitable Setbacks, and Other Weekend Reads

Next Article

Why Individual Investors Do So Poorly in the Stock Market

Related Posts
Subscribe to AdvisorAnalyst.com notifications
Watch. Listen. Read. Raise your average.