July 2011

Process over Outcome

Recently a client, after sitting through one of our investment presentations, remarked This is the complete opposite of what I heard yesterday from one of your competitors. They said equities are really cheap because P/E ratios are low and you guys are saying the polar opposite. So which is it? This is an interesting question and one we hear a lot at Covestone. Our answer to it is simple; next time someone makes a claim one way or another ask them to prove it. While opposing views are a prerequisite to the price clearing mechanism, many of the claims made about market valuation are not supported by robust evidence. As investors when we allocate capital we must be able to articulate an investment case which rests on hard evidence rather than conjecture. Of course that is not to say the competitor in question hadnt done their homework, we are merely making the point that there are a lot of nonsense claims made about value. So are markets cheap? Market cheapness as a condition is only satisfied if the observable data which indicates the appearance of value is consistently associated with strong subsequent returns. One year price earnings ratios may be low but they are very poor guides to subsequent future returns and therefore as an indicator of value they are not very useful. Weve crunched the data on one year P/E ratios and we cant arrive at the conclusion proffered by our competitor. For sure, we can graph 1 year forward P/E ratios and show how they are below 20 year averages, but the key point is that would not be a phenomenon consistent with high returns and thats before we question the arbitrariness of the 20 year time period used. For aggregate market valuation one year P/E ratios are very poor indicators of value. We have tested pretty much all of the valuation metrics that are out there over long time horizons (100 years+ in many cases). We find that for predicting returns from markets in aggregate most indicators are pretty useless however we did find that when used together a particular four metrics can explain about 75% of the subsequent 10

year movement in share prices. We have yet to see a better model at predicting long term price moves and consequently the combination of these indicators provides a solid foundation to our investment process. By way of comparison a one year P/E ratio explains about a fifth of the movement in 10 year returns and as for predicting where the market will go over the following year the explanatory power of a one year P/E ratio is, joking aside, about the same as deriving your buy and sell decisions from the weather (i.e. zero). Despite its lack of statistical credibility that metric is as popular as ever, largely because of its simplicity and flexibility (flexibility in the sense that the denominator can be switched with ease from reported earnings to operating earnings or forward to historic). Fundamental Outlook If one needs little or no evidence to support a claim it becomes very easy to construct an attractive narrative around any asset, after all there are always reasons to both buy and sell everything that can be traded. They key however is not to pick an arbitrary bullish or bearish strand of a story and allow it alone to form your view but to expend your energy on creating a robust process to weigh all the factors together which in turn generates an output which can be used to drive an investment decision. Figure 1: Fundamental outlook weighted down by debt

Source: Covestone Asset Management

In the main we let long term valuation indicators drive our investment process because, as mentioned above, they have an unparalleled record in predicting subsequent long term returns. However if we felt the fundamental environment was unusually positive we might accept the lower returns from our valuation model on the basis that higher than average valuations were justified, alas we dont! The coloured rectangles in Figure 1 above represent a simple summary of the main fundamental factors at play in the global economy right now. Weighing up the positives and negatives leads us to believe that developed world debt problems skew the fundamental backdrop into unfavourable territory. This predicates a degree of caution in how we allocate your capital and when we ally this with the unfavourable valuation conditions we believe that an equity weighting at the bottom of our ranges is warranted for the time being. The Importance of Process We, as individuals, are behaviorally hard wired to focus on outcomes rather than on the processes that generate those outcomes. As we know good processes can have bad outcomes and vice versa as randomness and chance will always play a huge part in driving outcomes, particularly over shorter time periods. A good investment process helps determine the expected risk and return characteristics of an asset and in doing so helps maximise long term returns. Given our long term focus and the emphasis we place on capital protection we are fastidious about getting our process right. A simple way of illustrating the importance of process over outcome would be to simulate a stockmarket where there is a 90% chance a particular market will go up 5% in a year and a 10% chance it will go down by 60% over the same period. There is no other outcome possible. You are not a rational investor if you chose to invest despite the fact that 90% of the time you may look clever if you focus just on outcomes. However a good process will tell us that we have a negative expected return despite the fact that we will make money 9 years out of every 10. That is why

the process is far more important than the outcome in investing. Many poorly managed hedge funds in recent years employed strategies which had a high probability of a small gain and a low probability of a large loss but when the loss struck its magnitude proved crippling, not least because leverage was involved. This is not unlike the strategies pursued by much of the banking sector over recent times where soaring asset to equity ratios ensured material losses would prove catastrophic - the phrase picking up dimes in front of a steamroller captures the point nicely. In all probabilistic fields the most successful players are process driven and in the same way good poker players can always assess pot odds good investors have a process to ascertain the potential risk and returns of an investment. The focus on process over outcomes is well understood by experts in other probabilistic disciplines, one illuminating example comes from the game of poker: Anytime you make a bet with the best of it, where the odds are in your favour, you have earned something on that bet, whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favour you have lost something, whether you actually win or lose the bet. You have the best of it when you have a positive expectation, and you have a positive expectation when the odds are in your favour. You have the worst of it when you have a negative expectation when the odds are against you. Serious gamblers bet only when they have the best of it; when they have the worst of it; they pass. David Sklansky, The theory of poker The basis of our investment process comes from our valuation model as displayed in Figure 2. Our model projects what long terms will be at any point in time. We showed this graph in last quarters newsletter but feel its worth repeating. The blue line represents what we believe the annual returns will be from equities over the subsequent 10 years from various starting points. This compares with the actual outturn which is represented by the red line. Encouragingly the two track each other tightly which in effect means that robust analysis of long term

valuation indicators can, as mentioned already, predict up to 75% of long term returns. At present we expect that real total returns from global equities will equate to about 0.5% annualised over the next decade (or 3.5% nominal). We expect bonds to deliver slightly less. The problem with this analysis, and this is its strength too, is that valuation doesnt work too well in the short term and that eliminates most of the investment populace from its fan base. The danger of market risk when valuations are high Not only have long term returns been poor from this starting point but investors buying at this level have also exposed themselves to a high risk of capital loss as figure 4 illustrates. Figure 3 breaks the projected long term returns from our model into quintiles (So the first bar represents all the points in history where our model predicted annual returns over 10 years would be less than 0.5% per annum, the second bar represents all the periods where the model suggested subsequent 10 year annual returns would be from 0.5% to 3% etc.) The size of the bar represents the average maximum five year loss from this starting level. In other words it is the worst loss an investor suffered when buying at that valuation level. As you might expect there is a clear causal link between starting valuation and subsequent drawdown (i.e. expensive markets are associated with large corrections and cheap markets are associated with far smaller corrections over the same time). Based on this analysis an investor buying equities now (i.e. at a level expected to give you about 3.5% before inflation for next ten years (or 0.5% after) has, on average, suffered a 33% fall from this level at some point in the following five years. Figure 3

On the subject of process In these newsletters we try hard not to waste paper telling you what has happened in markets nor do we like to opine about the unknowable, instead we try convey the thought processes which drive how we manage your money. Our goal as an asset manager is always to maximise the risk adjusted return of our funds. We like to think we do this through a considered and robust approach to long term investing. That is why most of our time is spent developing our investment process which we are confident can generate the best long term outcomes for our clients.

Current Positioning
The current composition of the funds is detailed in Figure 4 below. Warren Buffets quote lethargy bordering on sloth remains the cornerstone of our investment style neatly sums our first half strategy for the Conservative and Balanced funds over the first half of the year. The weightings in these two funds are almost identical to those which we began the year with and even with the benefit of hindsight we struggle to see what we, as stewards of your capital, would have done differently in 2011. We remain positioned as we see fit for the current environment: our equity weighting remains heavily tilted towards high quality large capitalisation stocks where we see considerable relative value, our bonds towards emerging markets and unconstrained strategies and our hedge funds towards those strategies which are uncorrelated to equities. In the Conservative and Balanced funds all equity and bond foreign currency exposure is hedged back to Euros. This will be our policy going forward as we wish to eliminate foreign currency risk from these funds. The Conviction fund is a far more unconstrained vehicle than the other two funds and has complete freedom to back its views. As a result we expect this fund will be either our best or worst performing fund over any quarter. In June we reduced the equity weighting in the fund from 30% to 5% as we lost conviction in risk assets. We are happy to maintain the high cash balance given the optionality it bestows. The Conviction fund is currently fully currency hedged but given the funds more aggressive strategy the fund may, from time to time, run an unhedged position. Since October of last year the cash balances in each of the three funds have been deposited outside of Ireland with both Barclays & Northern Trust. Figure 4:

Summer Reading
If anyone else is as sad as us and looking for some investment related books to read on the beach this summer we have added three gems to the Covestone must-read list.

The Most Important Thing: Uncommon Sense for Thoughtful Investors by Howard Marks. Howard Marks is the long time chairman of Oaktree Investments and one of the most lucid minds in the investment game. As Warren Buffett says about the book When I see memos from Howard Marks in my mail, theyre the first thing I open and read. I always learn something, and that goes double for this book. Endgame: The End of the Debt Supercycle and How It Changes Everything by John Mauldin and Jonathan Tepper. A powerful and sobering analysis of the debt crisis and its implications. The introduction gives you as taster: What were we thinking? In a way, we acted like teenagers. We made the easy choice, not thinking of the consequences. We never absorbed the lessons of the depression from our grandparents. We quickly forgot the sobering malaise of the 1970s We created liar loans, no-money-down loans, and nodocumentation loans and expected them to act the same way that mortgages had in the pastWhere were the adults supervising the sandbox? Drunkards Walk: How Randomness Rules our Lives by Leonard Mlodinow A wonderfully readable guide to the power of randomness and probability. Very much in the vein of Nassim Talebs great book Fooled by Randomness.

Neil Osborne, July 2011