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February 23, 2021
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A Memo to Investors

Stock Picking
Markets
Valuation
Asset Pricing
Behavioural Finance
Factors
Passive vs Active
Portfolio Management

Dear Stock Picker,

I know, these are weird and trying times.  It all makes you wonder what the point of stock-picking is.  What is the purpose of kicking the tires, looking under the hood, and doing our jobs?  

Michael Green at Logica, who is as smart as you like, will tell you the entire game now is all about passive flows, and that fundamental analysis is borderline useless. Cliff Asness at AQR, possibly an even smarter guy, will tell you that all this stuff we used to call alpha really was just factor exposure (e.g. quality, value) and there are cheaper ways to get it. Or perhaps fundamentals should matter, but Chamath Palihapitiya or Elon Musk will go out and buy OTM YOLO calls on some dog with fleas and then tweet “Gamestonks” to their hordes of acolytes – all but destroying normal price discovery.

   You take the blue pill, you wake up in your bed and believe whatever you want to.    

Despite the protestations otherwise, despite the popular view that the market is now purely narrative-driven, despite the recent emergence of wholly unfundamental stories like the one we all just experienced with Gamestop (and probably are still experiencing with Tesla[1]),and despite the power of Ben Graham’s voting machine; in my very strong view, the stock market will always eventually be a weighing machine.[2]

This surely will sound quaint and stale to a few readers, but – and I’m sorry – the future value of a thing is ultimately based on the dividends the thing will eventually pay you, or someone to whom you are prepared to sell your shares.  Whether the proxies for those dividends are cash flows, earnings, margins, sales, or the dividends themselves, alpha happens when expectations of those future dividends change.

That’s it.  That’s the stock-picking game.  Stocks are not pieces of art.  They are not fiat money.  Cults of personality do not last forever in the stock market.  Narratives break.  Eventually, everyone figured out that Galileo was right.  Eventually, everyone will figure out that Cathie Wood isn’t.  And it won’t take as long either.

Sure these individual mo-machines can raise money, and in terms of surviving, there is some degree of self-fulfilling prophecy.  Elon is being very smart about this.  So were the guys at AMC a few weeks ago (GME evidently couldn’t do anything about it because they were in a quiet period, but you can believe they wanted to).  But for those making money on big investments in these particular securities as they go from unreasonably overpriced to preposterously overpriced, this is not investing.  This is greater-fool speculation.  Sure, this is fun (for the longs); but calling it anything else is pulling the wool over the eyes of clients, or perhaps over your own.  

What may even have started as a reasonable and strong fundamental reason for ownership must be tempered if the share price of the thing is 10x higher than it was when you first established your thesis.  Price matters.  There is a difference between a company and its share price.  This gravity of this logic has not dropped on many market participants.  But it will. It always does.

As sure as the sun will come up tomorrow, there are some incredible overreactions happening right now in the stock market, and they will continue to happen. And it isn’t just for the things with rocket emojis lifting them off, but in the other direction as well.  

And this, my fellow stock-pickers, believe it or not, is GREAT for us.

Why? Because almost any overreaction not supported by a fundamental justification will eventually be valuable for opportunistic stock-pickers.  

Take these meme stocks for example. Using an analogy from popular culture, these stocks were/are being bought by participants controlled by the Matrix[3]. Morpheus hasn’t come to save them yet, and they haven’t had the red pill.  GME shareholders (for example)just got red-pilled; but at TSLA, Elon’s narrative machine is blocking production of red pills, so the masses continue to enjoy the ignorant bliss of naïve optimism.

There are countless (well, not countless) other overpriced and underpriced securities.  And when Ben Graham’s weighing machine eventually shows up – and it will – we, very simply, are going to have the opportunity to capture alpha that the factor machines and index funds can’t.

And this isn’t just about stock-picking, it is about your portfolio.

By definition, you can’t have a big, diversified portfolio that captures alpha.  That was true even before value, momentum, quality and investment factors arrived; and it is even more true today.  If there is any alpha out there, anything left over after throwing all those factors in the regression equation, any reward for more objectively analyzing the right information and concluding that the market has it wrong, then those opportunities are only few and far between.

For the individual investor, this means buying index funds, and reserving a small amount (like, 5-10%) for the fun stuff.  

For institutional investors, you need to be smart about paying very little (a.k.a. nothing) for market exposure and little for factor exposures.  If you want to beat the market without making a huge style bet, you must invest a small portion of you larger equity portfolio in concentrated managers.  That’s just math.  But at the same time, you must ensure these investments are neither too correlated nor too diversified across these concentrated equity managers.  

And for the equity manager providing that service to institutional partners, one that is not interested in asset gathering but driven by a motivation to seek alpha, this is where you step in.  Build concentrated portfolios, provide (hopefully) process-led excess returns to aligned clients, create wealth and stability for retirees, endowments, and make markets efficient.

Eschew the blue pill and keep discovering how deep the rabbit hole goes.

And stay in the game.

 

Happy Hunting,

Drew


FOOTNOTES

[1] https://www.marketwatch.com/story/ive-pulled-out-all-the-stops-for-tesla-but-cant-find-the-upside-on-the-stock-11610117368

[2] https://www.albertbridgecapital.com/post/voting-machines-and-weighing-machines

[3] Reference and Photo Credit: The Matrix (1999) Warner Bros., Village Roadshow Pictures

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Topics

Stock Picking
Markets
Valuation
Asset Pricing
Behavioural Finance
Factors
Passive vs Active
Portfolio Management

DISCLAIMER

The views and opinions expressed in this post are those of the post’s author and do not necessarily reflect the views of Albert Bridge Capital, or its affiliates. This post has been provided solely for informational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The author makes no representations as to the accuracy or completeness of any information in this post or found by following any link in this post.

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Albert Bridge Capital manages concentrated long-only equity portfolios for institutional investors.The hallmark of its Alpha Europe strategy is the application of tenets of behavioural finance to a rigorous, fundamental, process-oriented research process.

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A Memo to Investors
Investors? Possibly you!
Avengers Assemble!
How Did This Even Happen?
Was “Value” Just a Hot Hand Thing?
The Hot-Hand Fallacy Fallacy Fallacy?
Cue the Camouflage
The Times that Try Stock-Pickers’ Souls
A Different Game?
Heads I Win
A New Ice Age?
Grandpa Stocks
Bubblicious?
On Negative Oil and Futures Prices
In Flew Enza
COVID-19 and Equity Markets
Regulators to the Rescue?
Perspective
We Don’t Make Pizzas
Ben Graham the Growth Investor?
Not a Bad Decade
On the Impact of the FAMANGs
Europe vs the US: Is it all about sector exposures?
Behavioural Finance is Finance
America’s Decade
Known Unknowns and Share Prices
Prediction, Publicity, and Paul the Octopus
Are Company Visits Good or Bad?
Everybody Was Kung Fu Fighting?
Voting Machines and Weighing Machines
The DCF is the Randy Watson of Valuation
The Sacrilegious Diaries: Measuring the Impact of Portfolio Turnover
Passively Irrational?
Imagine No Inflation
The Sacrilegious Diaries: The Benefits of Turnover
Stay in the Game
I’m Volatility?
Woody was Right
When You Can’t Wait For Tomorrow
James Harden and Alpha
Groundhog Day and Overnight Returns
Debiasing and Alpha
Peak “Peak Car” ?
The Right Way
The First Step to Regaining Credibility
The Futility of Market Timing
Visualizing the Arithmetic of Active Management
123 Years of the Dow
Sweet Emotion?
Share Buybacks, Bad Companies, and Bear Markets
Risk and Portfolio Theory
Keeping Calm and Carrying On
Reminiscences of a Stock Operator: The Volkswagen Chronicles, Ten Years Later
We’d Rather Not Sleep
Factor Timing, Should You Try?
The Mathematics of Maintaining Bet Size
The Grandfather of Behavioural Investing
On Sexual Chocolate and Semi-Annual Reporting
Island Economies and Risk
Build a Bear?
Data Science and Alpha
We’re all Value Investors
Hunting for Alpha
Career Risk, Alpha, and Contrarian Investing
Passive Flows and Wheelbarrows
God Bless the Shorts
Sell in May, and Go Away?
Equilibrium Happens
Horses and Stocks
Peak Quality?
Bill Sharpe and Hank Aaron
Unwarrented
The Search for Excellence and the Loser’s Game
Fooled by Non-Randomness
Half Hearted Is Half Minded
Still Superman, but without the cape
122 year Dow Jones Histogram: Putting 2017 into context
Pegs, P/E'S and the Value Premium
Rick Barry and Lewis Carroll
Secular Winners and Value Investing
Robots and Alpha
The Voting Machine
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