Global Return Asset Management annual letter for the year ended December 31, 2016.
2016 Hedge Fund Letters
In 2016 we generated a 7.10% net return and ended the year with nearly 15% of assets in Cash.1
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Our Q4 2016 activity includes the following:
In the letter below I provide details on our investing activities and an update on our portfolio. I then explain how the investment industry has confused the cause-and-effect relationship between risk and volatility. Following this is a discussion of how we view risk within a company. Finally, I end with an outline of our portfolio.
Please contact me if you have any questions or would like to discuss my investment strategy or risk management principles.
Before detailing our activity for the year, I want to comment on the endless debate of “passive versus active investing.”
I think it’s important to understand what constitutes “active” and “passive” investing. The conventional definition is that active investing is anytime a portfolio manager buys a group of stocks that don’t mirror an index.4 Conversely, passive investing is buying an exchange-traded fund (ETF) that mirrors an index. However, these definitions aren’t robust.
For example, how long an investor holds an ETF and how different ETFs are weighted within an investor’s portfolio could put “passive investing” squarely in the “active investing” category. As for active investing, is holding the same stocks for five years really “active investing”?
Global Return falls in the active investing category because the stocks we buy don’t mirror an index. However, our average holding period is nearly four years, which we don’t consider as active, and I’ll wager many self-proclaimed passive investors don’t hold ETFs this long. We also hold cash when we can’t find opportunities that meet our strict criteria, which is an active decision, though some people might argue this is passive. Although, it requires significantly more discipline to sit with cash than to buy or sell an ETF.
Candidly, I think both strategies offer return-generating opportunities. For people who care to have it, my suggestion is to explore both options before deciding where to place your money and remember you can use both strategies.
With that said, for the full year, we entered six new positions, exited 10 positions, and increased 10 positions. Additionally, two existing positions were increased and then sold in later months and two
positions were entered and exited during the year.
At the end of 2016 we had 22 positions, 21 were common stock and 1 was a convertible warrant. I have two positions I’d like to sell but nowhere to place the proceeds; with nearly 15% of assets in cash it seems unreasonable to sell these positions, especially since they’re yield on cost is about 4.6%.
As discussed in previous letters, a study of our returns indicated I need to reduce the number of positions we have and increase the amount of capital allocated to our highest conviction positions.
As the amount of capital allocated to each position increases, it’s possible that the volatility of our portfolio increases but ideally so to should our results. It’s also entirely possible our portfolio’s volatility does not increase and I explain why in next quarter’s letter. Irrespective, an increase in volatility doesn’t worry me because volatility isn’t risk and below I explain why.
Cause and Effect: Volatility Isn’t Risk
The NYU Stern School of Business is home to the Volatility Institute. Per their website, “The Volatility Institute’s mission is to develop and disseminate research on risks in financial markets and closely related topics in financial econometrics.” If volatility interests you, I highly recommend attending their conferences or taking a few classes, they’ve been immensely helpful in shaping my views on volatility.
In the analysis below I only discuss “volatility as risk” when asset prices are declining. I’ve never heard anyone worry about volatility when asset prices were increasing, so there’s no reason to discuss this.
Let’s begin with defining volatility – it’s the standard deviation of returns for an asset5 or a measure of how much a return fluctuates around its mean6.
What causes volatility? The genesis of volatility is unexpected negative information.7 Following the release of unexpected negative information, market participants sell the asset which creates volatility.
Why does unexpected negative information cause volatility? Because the information reveals previously unknown risk.8
This illustration highlights the important distinction between risk and volatility – volatility isn’t the cause of risk, it’s the effect of risk.
Therefore, analyzing volatility or investing to volatility isn’t the solution for reducing risk. The solution for reducing risk is to identify the sources of risk in an asset and understand how they could cause a revaluation of the asset.
In the following section I outline how I identify and analyze sources of risk in our prospective investments.
Identifying Risk in a Company
A business is a collection of risk variables. These variables include (but are not limited to) the business model, customers, suppliers, operating expenses, competitive advantages, demand/supply elasticity, competitive forces, etc. Importantly, risk variables directly impact a company’s profitability and thus its valuation.
At Global Return, we attempt to identify each risk variable in a prospective investment. Once the risks are identified, we try to understand how changes in them could impact the company’s profitability and by how much. We believe this is the key to minimizing losses – understanding the sources of risks within our assets’ and how they could impact valuations.
Types of Risk
Risks that reduce a company’s value are uncompensated risk. The reason for this is obvious – an investor assumes the risks of an asset when he buys it, yet if the asset loses value because of the risk then the investor has bought uncompensated risk.
Conversely, risk that increase a company’s value is compensated risk. Again, the reason should be obvious – companies take risks to generate returns and if they’re successful the risk is compensated.
Finally, risk can be fixed or fluctuating and the example below shows how.
Here are several risk variables of a bricks-and-mortar retail company:
With a high-level of probability, can you determine which risks could change and how these changes would impact the company’s profitability and thus its valuation?
The key to successfully answering this question is understanding the gargantuan difference between possible and probable. It’s possible to quantify the risks that have been deleted but not with a high degree of probability, which means we can’t determine the prospective investment’s risk/reward ratio, so we must pass on the investment.
Some people might say, “Just look at past data.” These people might be correct with some industries but not with the retail industry.
Look at risk variables #2 and #3 – these are fixed because they’re unlikely to change without advance notice. Conversely, risk variables #8 and #9 are fluctuating because they regularly change and will do so without advance notice. This implies investors should approach fluctuating risks with more caution because they have a higher probability of igniting unexcepted risk, which will lead to a revaluation of the asset.
Risk variables can also change from compensated risk to uncompensated risk and vice-versa. For example, an increase in risk variable #8 and a decrease in risk variable #9, would reduce the retailer’s ability to pay the expenses associated with risk variables #2 and #3. Therefore, the changes in variables #8 and #9 would convert variables #2 and #3 from compensated risk to uncompensated risk – and if you follow retail stocks you know why – because the market will quickly and dramatically revalue a retail company when it receives “unexpected negative information.”
Here we see how risk grows or diminishes as it and its ecosystem evolve. On their own, risk variables #2 and #3 may not be risky but now two fluctuating risks have impacted them and made them riskier. It’s the interaction between risk variables that makes risk amorphic and idiosyncratic, or in this scenario, transforms compensated risk into uncompensated risk.
This illustration offers several insights. First, risk exists in many different forms, is often latent, and can grow or diminish as it and its ecosystem evolve. Second, relying on past data to determine future results can be measured with possible outcomes but not always with probable outcomes. Finally, when certain risks coalesce, it’s possible that “unexpected negative information” is revealed causing market participants to revalue an asset, which leads to volatility.
What’s the Solution?
Investors need to understand the risks imbedded in a prospective investment – what are they, how do they interact with each other and what could influence them that would ignite uncompensated risk?
Following, investor’s needs to determine, with a high degree of probability, whether the current share price of the company offers a sufficient return given the inherent risks.
To us, investing is the act of purchasing risk. Therefore, security analysis is risk analysis, the two are the same. Obviously, our goal is to invest in companies with compensated risk that offers a high probability of achieving the risk/reward ratio we seek. We believe our approach to risk analysis is one of the hallmarks that has contributed to our success, our below-industry volatility and above-industry returns.
I have no prognosis for what the market will do in 2017. As stock prices decline, the sentiment of my letters will change to bullishness. I yearn for declining prices because this is when our Cash is most productive – I can buy more stock with less money. It should not be ironic that declining prices offer reduced risk and increased returns, which, after all, is what every investor wants.
At the organizational level, I’m very happy with our progress. We continue adding clients to our alreadyimpressive roster. Equally important, Marius Morar joined us last year and has been an incredible asset to me and Global Return. I’ll have much more to share about him in next quarter’s update.
Please contact me if you would like to discuss my investment or risk management strategy.
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