Keynes Applied To Investing Today

Recently, both Bloomberg and the Wall Street Journal ran pieces that highlighting the investment successes of John Maynard Keynes.  Both emphasize how little Keynes actually applied his economic theory to investment; instead, focusing on how Keynes operated in a very Warren Buffett-like manner.  Keynes focused on valuation, applying probablistic analysis in order to decipher his risk/reward.  It's enlightening to learn about Keynes' role as an active participant in markets, but these articles seem to be saying that while Keynes is the father of macroeconomic theory, he was not a macroinvestor, but rather a micro investor.  In black and white terms, this is true; however, it is Keynes' superior understand if the macro landscape that I think led him to this conclusion and this chart of his performance as both a macro and micro investor should serve as a warning to many of the macrotourists out there today (Chart from Jason Zweig's article: Keynes: One Mean Money Manager):

In fact, from a reading of The General Theory, it becomes clear that Keynes' deep understanding of the role of behavioral economics, credit cycles, and the marginal efficiency of capital on investment played a crucial role in his realization that company-specific investments based on valuation made the most sense.  Keynes' description of the stock market as a beauty contest should strike any reader of Benjamin Graham as akin to the Mr. Market analogy.  Clearly Keynes recognized the connection between the emotional fluctuations of market temperment and its role in leading to over and undervaluation on the micro level.

Here I have pulled together 12 separate passages from Keynes that in my opinion are very relevant for today's economy.  Many of these help highlight how his understanding of macroeconomics ultimately led to the conclusion that a valuation-focused investment strategy is superior, while others provide key insights to investors of all types on how and why things are shaping up as is today in the broader economy.  One theme clear throughout is Keynes' understanding that a capitalist democracy inevitably requires certain bargains between capital and labor in order to survive, but that regardless, it is necessary for long-term investors to maintain an opportunity to profit.  Further, Keynes' disdsain for speculators in contrast to investors is clear throughout, and this is an area which I think requires more discussion today.

1. “It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated…with present-day capitalistic individualism.  But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.”

2. “There are valuable human activities which require the motive of money-making and the environment of private wealth-ownership for their full fruition….It is better that a man should tyrannise over his bank balance than over his fellow-citizens; and whilst the former is sometimes denounced as being but a means to the latter, sometimes at least it is an alternative…The task of transmuting human nature must not be confused with the task of managing it.  Though in the ideal commonwealth men may have been taught or inspired or bred to take no interest in the stakes, it may still be wise and prudent statesmanship to allow the game to be played, subject to rules and limitations, as long as the average man, or even a significant section of the community, is in fact strongly addicted to the money-making passion.”

3. “Changing views about the future are capable of influencing the quantity of employment and not merely its direction.”

4. “A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit.  But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both.  For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition.”

5. “But the daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current investment.  For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit.  Thus certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur.”

6. “There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable….human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate….Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money….Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.”

7. “The explanation of the time-element in the trade cycle, of the fact that an interval of time of a particular order of magnitude must usually elapse before recovery begins, is to be sought in the influences which govern the recovery of the marginal efficiency of capital.”

8. “As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase.  In one of the greatest investment markets in the world, namely, New York, the influence of speculation…is enormous.  Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market….Speculators may do no harm as bubbles on a steady stream of enterprise.  But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.”

9. “Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive a activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic.  Most probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits–of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

10. “It is curious how common sense, wriggling for an escape from absurd conclusions, has been apt to reach a preference for wholly “wasteful” forms of loan expenditure rather than for partly wasteful forms, which, because they are not wholly wasteful, tend to be judged on strict “business” principles.  For example, unemployment relief financed by loans is more readily accepted than the financing of improvements at a charge below the current rate of interest; whilst the form of digging holes in the ground known as gold-mining, which not only adds nothing whatever to the real wealth of the world but involves the disutility of labour, is the most acceptable of all solutions.”

11. “The later stages of the boom are characterised by optimistic expectations as to the future yield of capital-goods sufficiently strong to offset their growing abundance and their rising costs of production and, probably, a rise in the rate of interest also.  It is of the nature of organised investment markets, under the influence of purchasers largely ignorant of what they are buying and of speculators who are more concerned with forecasting the next shift of market sentiment than with a reasonable estimate of the future yields of capital-assets, that, when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force.  Moreover, the dismay and uncertainty as to the future which accompanies a collapse in the marginal efficiency of capital naturally precipitates a sharp increase in liquidity preference.”

12.  “Later on, a decline in the rate of interest will be a great aid to recovery and, probably, a necessary condition of it…. But, in fact…it is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world.  It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism.  This is the aspect of the slump which bankers and business men have been right in emphasising, and which the economists who have put their faith in a “purely monetary” remedy have underestimated.”

European Investing Summit: How Superinvestors are Navigating the EU Crisis

Last week, in addition to attending in person the Santa Fe Institute conference, I also “virtually attended” the European Investing Summit put on by ValueConferences and the Manual of Ideas.  It too was quite the experience, in terms of the quality and quantity of content and its groundbreaking format for connecting global value investors.  These days it’s nearly impossible to amass the brainpower and experience of informed presenters in one conference room over the course of two days in any physical sense.  That’s why the Manual of Ideas had the idea to orchestrate a virtual conference, with a blend of live streaming and pre-filmed interviews, replete with presentations and interactive conference rooms to connect with fellow attendees and presenters alike.   Many thanks to John and Oliver Mihaljevic for conceiving and executing on an outstanding idea, and for gathering some of the foremost talent in the industry.

I spent a whole lot of time last week and over the weekend listening to and absorbing as much as I could from the videos.  I particularly liked the fact that nearly all of the videos offered great lessons on the process and philosophy side as much as they did on the ideas front.  I went into the conference with plenty of thoughts on Europe and where I saw the crisis inevitably leading to, plus I had already deployed capital strategically into four distinct European investment opportunities, but I really wanted more considering the vastness of opportunity amidst crisis. (Be sure to check out my post connecting Europe today to the Articles of Confederation USA entitled The Answer to the Eurozone Crisis was Written in 1787).

I “left” the conference having learned of several very intriguing ideas that are queued up for immediate further inquiry, but maybe even more importantly, I “left” feeling like I made important strides in continuing the evolution of my own investment philosophy.  In this blog post, I would like to share some of the more macro ideas from the live sessions on day 1 of the conference, including perspectives on the European markets and some important philosophical points on value investing in this present environment.  Anyone who finds these ideas remotely intriguing would extract considerable value from attending these online sessions at ValueConferences.com.

Guy Spier, Managing Partner, Aquamarine Capital

The live portion of the event kicked off with Guy Spier’s keynote address on “Investing in Europe in the Face of Crisis and Uncertainty.”  Spier started his analysis with some very informative charts on the debt-to-GDP ratios of the various EU entities, including a breakdown between public, private and corporate debt.  There were some interesting observations on the charts, including just how troubled Greece is from a public debt perspective, how much greater Ireland’s aggregate debt burden is compared to the rest of the EU and US, and how much actual private wealth exists in Italy.  Obviously we all know about Greece’s woes, but I think in valuing investing circles, the troubles of Ireland stand in stark contrast to conventional wisdom, and Italy’s wealth is often overlooked (this is something I’ve covered on my blog in the past in a post called Why Italy Doesn't Worry Me).

In my opinion, one of the more important points Spier made off of these charts is that “fear-mongers try to make money off of selling fear, but the globe has a whole lot more wealth than is ever talked about.”  This is exactly how crises go.  People get caught up in the negative emotion and willfully look past some crucial realities. 

We then turned to a chart on the odds of a country leaving the EU, which has greatly decreased since ECB President Mario Draghi’s aggressive late summer statements and actions.  This segued nicely into how Guy in the recent past thought the Euro would in fact break up, however, politics, not economics paved the way for Draghi to bypass the rules in practice, and keep the currency union together.

Next Spier broke down the two lenses through which people view this crisis: the Anglo Saxon vs. the Continental.  Anglo Saxon countries are more individualistic and place a greater degree of value on personal freedom, whereas the Continental lens is more collectivist.  This creates a dichotomy whereby those who adopt the Anglo Saxon perspective view the crisis through an economic lens, while Continental people take the political view.  Each perspective has its own unique consequences; however, it’s clear that today the Continental approach is winning. 

Spier himself asserted that he has moved his understanding in the Continental direction.  This then evolved into a discussion on how the crisis itself is a catalyst for further integration to the point where without crisis, integration itself stagnates.  That raises the question of whether crisis is desired amongst those integrationists like Draghi, for without it they cannot continue the mission of Jean Monnet.

Please note: Spier then gave some very interesting investment ideas, but again, my focus here is to outline the European perspectives and what I learned philosophically about value investing.

Charles De Vaulx, Chief Investment Officer and Portfolio Manager, International Value Advisers

Right off the bat, De Vaulx continued on this theme of an Anglo Saxon/Continental divide: “Investing has always been an Anglo Saxon endeavor…it’s mostly those countries that have relied on capital markets to advance capital formation, while other countries saw their capital formation financed in other ways.”  De Vaulx then launched into a great history of value investing, and how it had predominantly been an American, and then British phenomenon.  Starting with the early 1990s recession, great American investors like Tweedy Brown and Michael Price ventured into global capital markets for value, mainly Europe.

Why did these investors turn to Europe? De Vaulx argues that this is due to some of the competitive advantages offered by European reporting.  Before the adoption of international account standards in Europe, man companies made it easier for some equities to get mispriced, or they ended up undervalued due to very conservative accounting practices (the opposite of many other places in the world).  In many of these cases, true economic earnings were thus understated.  Likewise, many companies had hidden assets on their balance sheets that were booked at historical cost, rather than present value.

Previously, the abundance of family owned and controlled businesses had been thought of as a risk in Europe, yet on further analysis, it became clear that these families were true stewards of investor capital, with their risks aligned in an advantageous way.  Further, many were open to the idea of takeovers and/or mergers as a means through which to realize value. 

Right now, International Value Advisers has 10% of the fund invested in France and only 0.4% in Germany.  This sits in contrast to much conventional wisdom, which holds that Germany is the safest, and France’s regime will crush capitalism.  Many companies across Europe, and particularly in France are in actuality global businesses, with a plurality of income generated overseas (De Vaulx used Vivendi and Total as examples here).

Over the course of the Euro Crisis there has been a big distinction in stock performance between the quality businesses and the cyclical ones.  Right now, many of the high quality businesses have performed very well, and thus are not cheap, while the cyclical businesses have become increasingly depressed.  Because of this contrast in performance, De Vaulx has been selling some quality businesses and allocating more capital towards the cyclical ones.  Because of this dichotomy, if you look at Europe in aggregate, the markets look very cheap; however if you want to buy quality you have to be willing to pay up.

Interestingly, De Vaulx had two impactful statements which contrast with typical value investing theory: first, he said that “gold has a lot to do with value investing and has a lot to do with Europe” as a hedge against problems; and second, he said that “buy and hold should not be part of the value investor’s vocabulary right now” due to the heightened volatility, which will be with us for a while.  This is an interesting adaptive change for a long-time value investor. 

Alvaro Guzman de Lazaro Mateos, Managing Partner and Portfolio Manager, Bestinver

Bestinver is a long only, no derivatives value investing group that follows macro, but doesn’t invest it.  Guzman de Lazaro focuses much attention on the reasons why a security has become cheap, and when an answer is readily identifiable, he invests so long as the reason for cheapness are acceptable.  In Europe, much of their attention is focus on family owned companies, companies with weird share structures, long-term projects and under-the-radar small caps.

Guzman de Lazaro observed that by and large, “Europe is a less efficient market” and in my opinion, this is music to any value investor’s ears.  For without inefficiency, there cannot be value, and the greater the degree of inefficiency, the greater the opportunity.  Guzman de Lazaro continued that in the US there is far more competition amongst the various value investors, and competition drives down return.  With European family owned businesses, there is a unique opportunity to engage with the families in order to develop a synergistic relationship over the course of years.  These families start to see their big investors as partners, and take their input in capital management.

Typically, Bestinver will look for companies with high barriers to entry, trustworthy management, little or no debt, and the stock already down quite a bit, all the while value itself should be growing.  What they prefer is a stock to drop solely due to concerns about the European Union itself, and not the fundamentals of the business.  Guzman de Lazaro emphasized the importance to their margin of safety of the increasing of intrinsic value while the price either stagnates or drops lower.  This creates a situation where over time the company has gotten cheaper.  Because a breakup of the EU cannot be taken off the table, Guzman de Lazaro models each company accounting for a 40% devaluation in their respective domestic businesses. 

Guzman de Lazaro also presented two excellent ideas, one of which is now on my immediate research list, and I urge you all to check out the European Investing Summit to learn more.

Jochen Wermuth, CIO and Managing Partner, Wermuth Asset Management

Jochen Wermuth is an investor focused on Russia and his presentation was appropriately titled, Russia: Klondike or Eldorado?  I went into the presentation disliking Russia and wanting to dislike it more.  Everything we hear about the country is of government and corporate corruption alike, with a near dictatorial leader imposing his well as he sees fit.  While there is certainly much merit to these complaints, Benjamin Graham certainly would still invest in a cigar butt were the valuation cheap enough, with little regard to the quality of the business itself.  And it does seem like Russia has some impressive numbers working in its favor, and we’re talking verifiable, not corruptly skewed numbers here too.

Wermuth started with the assertion that valuations are extremely depressed, and the reasons are twofold: the perception issues cited above, and a dose of truth.  The government has been increasing its share in the economy, and extracted significant value from the oil sector in order to build a substantial sovereign wealth fund.  To that end, there have been rollbacks in the pace of privatizations, and more dangerously, people in the country have been deeply upset by corruption to the point where they want to leave.  As a result, the country’s equity risk premium now sits at 17%--all-time highs, and a 36% discount to its average PE over time, and a 58% discount to the rest of the BRICs.

That starts us on the good stuff—the country is priced for the worst case scenario.  Importantly, government debt, as it stands right now, is at 10% of GDP and the country has zero debt denominated in foreign currencies.  This is in stark contrast to many other countries around the globe.  Plus, Russia has $520 billion of its own FX reserves, the 3^rd largest stash on the planet.  This is a very different Russia than the one which defaulted in 1998.

As it stands right now, market infrastructure is not very developed, with foreign capital the primary “bid.”  Pensions in Russia are small and cannot invest in equities, therefore the market really just moves along with the flow of international capital.  When the tide rides in, valuations rise, and when it leaves, they decline.  Further, speculative flows focus on only a few sectors (i.e. the love for emerging market consumers) to the point where there are substantial valuation gaps between the sectors.  Liquidity (or the lack thereof) compounds these problems, are brokers only push their international clientele into the most liquid vehicles, not the cheapest, best investments.

John Gilbert, Chief Investment Officer, General Re-NEAM

Although this was dubbed the European Investing Summit, John Gilbert focused his really thorough presentation on the present state of the US economy and its implications for long-term investors.  Gilbert posted some outstanding charts highlighting the state of the economy today and how it has changed over time.  One of the first observations was that both household net-worth to disposable income and household net worth to debt have both improved since the crisis began, albeit not very much overall.  Plus the savings right, while higher now, has to potential to get even more elevated.

Financial sector debt-to-GDP has risen from “virtually zero” in 1952 to a peak of 120% of GDP in the bubble days, back down to about 90% now.  Deleveraging has been particularly rapid in this sector of the economy, but it “may have considerably further to go.”  Leverage in the shadow banking arena (mortgages, ABS and other) is greater than in the traditional financial sector now, and this can be attributed to the financialization of the economy.

Gilbert then asked rhetorically, “how far along are we on deleveraging, and how much further do we have to go?”  In 2011, the Bank of International Settlements presented a paper at Jackson Hole called the “Real Effects of Debt.”  The BIS outlined how in each of the 3 sectors, levels of 85-90% of GDP correlate to slower subsequent economic growth.  We are still in this danger zone.

Many optimists point to the debt service as a percent of disposable income in order to say thing are getting better, and the Fed does this too (for my Twitter followers, you know I’m guilty as charged here too…see the chart for yourself here).  Gilbert says “it is quite encouraging” and certainly has some merit, and says the reasons behind this are the Fed’s zero interest rate policy (ZIRP) and what that has done to create low mortgage interest rates.  However, Gilbert would caution that the balance sheet itself remains quite stressed and this leaves the household sector vulnerable to any subsequent shocks.

Historically, the largest source of deleveraging has been from increases in nominal GDP, most specifically inflation.  While there are no imminent signs of inflation, this is a good template through which to expect future deleveraging to take place and its worth looking at where inflation might come from.  Plus, the aid of inflation in decreasing debt burdens can be quite large even when the overall inflation rate is low.  Policymakers are aware of this, but there problem is that it’s tough to get inflation started in the short run. 

Housing is typically a good source of inflation, although it “won’t surge anytime soon.”  It is clearly off the bottom today, and we’re heading in the right direction.  Single family rental rates (or the bond equivalent value of owning a home) has diverged sharply from the price of actually owning a home.  This makes renting more expensive relative to housing and pushes would be renters into homeownership.  This is a good positive for housing.

As for Fed policy, QE3 is different from its predecessors both in terms of conditions in advance (they’re a bit better now) and in the way it’s done (open-ended purchases of MBS instead of fixed amounts of Treasuries).  This marks an important “cultural change in the Fed” that is moving towards unanimity in the dovish direction.  We can see this in how certain members have changed their positions to align with Chairman Ben Bernanke.  Since QE3 is tied with the Fed’s goal of “maximum employment” we must then examine what that term means.  Gilbert defines it as “the rate when the economy is at potential and not exerting pressure on inflation.”  The problem is that this rate shifts over time, and is not observable.  It therefore “must be inferred from the condition of the labor market.”

One way that policymakers try to figure out “maximum employment” is through using the Beveridge Curve.  This plots the unemployment rate against the job opening rate.  There are two problems with this analysis: the natural employment rate is subject to error, and there is a big spread between the real-time data and revisions down the road.  Right now it’s too early to form any strong opinions about the labor market, as to whether there has or has not been structural change in the economy.  The Fed is inclined to say there is not; however, Gilbert is a bit more skeptical and wants to wait to make any judgments.

Everyone today is looking for more yield, but it’s important to remember that these are troubled times and more yield involves more risk.  We are approaching tight corporate bond spreads on high quality stuff, but not quite yet on high yield.  There are many anomalies in markets due to this chase for yield, including: electric utilities trading at their highest P/E relative to the S&P ever, the Schiller CAPE/Tobin Q are not all that cheap right now; Gold has outperformed the S&P despite not being a good long-term investment in its own right.  Gilbert elaborated on gold saying that once in a while it acquires option value, but doesn’t pay off very often.  It is “only in the money when people lose faith in the existing monetary standard” and considering that faith has not broken, gold “is a candidate for a bubble.”

In conclusion, Gilbert explained that it’s too early to say whether there has been a permanent behavior change following the recent crisis, but it’s significant that most people alive today have never seen anything other than credit inflation.  Lehman itself upended 200 years of lender of last resort behavior, and this in and of itself could have far- reaching consequences down the road, leading people to take on less debt for a long time, and/or possibly inducing central banks to be more aggressive than they have been.

I had the opportunity to ask a question, and I asked: “you referenced the connection of maximum employment to NGDP and the Fed’s new form of QE2 as a more forceful push towards maximum employment.  Do you then view QE3 to be the fed’s adoption of NGDP targeting?”  Gilbert answered that it’s not quite there, because there are technical problems with targeting NGDP.  He does however expect the idea of NGDP targeting to get more attention, because it would allow the Fed to let inflation rise without actually saying so. 

Gilbert continued to explain that If we end up in a world where the US is not a real growth economy, but a 2% real GDP growth state, and you set an NGDP target of 5%, this lets your target inflation rate rise from 2% to 3% without actually doing anything.  Further, he said that it’s hard to see QE3 having the transmission mechanism to support such a substantial change in their targeting.  They’re solely resorting to increase the quantity of money right now, rather than the cost of money, which is what NGDP would do.  For that reason, the Fed might have to take more radical steps were they to actually adopt NGDP targeting as its policy.

How did Ed Thorp Win in Blackjack and the Stock Market?

My earlier post laid out some important lessons on behavioral economics learned from Santa Fe Institute’s conference on Risk: the Human Factor.  The specific lecture that first caught my eye when I saw the roster was Edward Thorp’s discussion on the Kelly Capital Growth Criterion for Risk Control.  I had read the book Fortune’s Formula and was fascinated by one of the core concepts of the book: the Kelly Criterion for capital appreciation. Over time, I have incorporated Kelly into my position-sizing criteria, and was deeply interested in learning from the first man who deployed Kelly in investing.  It's been mentioned that both Warren Buffett and Charlie Munger discussed Kelly with Thorp and used it in their own investment process.  Thus, I felt it necessary to give this particular lecture more attention.

In its simplest form, the Kelly Criterion is stated as follows:

The optimal Kelly wager = (p*(b+1)—1) / b where p is the probability (% chance of an event happening) and b is the odds received upon winning ($b per every $1 wagered).

It was Ed Thorp who first applied the Kelly Criterion in blackjack and then in the stock market.  The following is what I learned from his presentation at SFI. 

Thorp had figured out a strategy for counting cards, but was left wondering how to optimally manage his wager (in investing parlance, we’d call this position sizing).  The goal was a betting approach which would allow for the strategy to be deployed over a long period of time, for a maximized payout.  With the card counting strategy, Thorp in essence was creating a biased coin (a coin toss is your prototypical 50/50 wager, however in a biased coin, the odds are skewed to one side).  This question was approached from a position of how does one deal with risk, rationally?  Finding such a rational risk management strategy was very important, because even with a great strategy in the casino, it was all too easy to go broke before ever attaining successful results.  In other words, if the bets were too big, you would go broke fast, and if the bets were too small you simply would not optimize the payout.

Thorp was introduced to the Kelly formula by his colleague Claude Shannon at MIT.  Shannon was one of the sharpest minds at Bell Labs prior to his stint at MIT and is perhaps best known for his role in discovering/creating/inventing information theory.  While Shannon was at Bell Labs, he worked with a man named John Kelly who wrote a paper called “New Interpretation of Information Rate.”  This paper sought a solution to the problem of a horse racing gambler who receives tips over a noisy phone line.  The gambler can’t quite figure out with complete precision what is said over the fuzzy line; however, he knows enough to make an informed guess, thus imperfectly rigging the odds in his favor. 

What John Kelly did was figure out a way that such a gambler could bet to maximize the exponential rate of the growth of capital.  Kelly observed that in a coin toss, the bet should be equal to one’s edge, and further, as you increase your amount of capital, the rate of growth inevitably declines.

Shannon showed this paper to Thorp presented with a similar problem in blackjack, and Thorp then identified several key features of Kelly (g=growth below):

1. If G>0 then the fortune tends towards infinity.
2. If G<0 then the fortune tends towards 0.
3. If g=0 then Xn oscillates wildly.
4. If another strategy is “essentially different’ then the ratio of Kelly to the different strategy tends towards infinity.
5. Kelly is the single quickest path to an aggregate goal.

This chart illustrates the points:

The peak in the middle is the Kelly point, where the optimized wager is situated.  The area to the right of the peak, where the tail heads straight down is in the zone of over-betting, and interestingly, the area to the left of the Kelly peak corresponds directly to the efficient frontier. 

Betting at the Kelly peak yields substantial drawdowns and wild upswings, and as a result is quite volatile on its path to capital appreciation.  Therefore, in essence, the efficient frontier is a path towards making Kelly wagers, while trading some portion of return for lower variance.  As Thorp observed, if you cut your Kelly wager in half, then you can get 3/4s the growth with far less volatility. 

Thorp told the tale of his early endeavors in casinos, and how the casinos scoffed at the notion that he could beat them.  One of the most interesting parts to me was how he felt emotionally despite having confidence in his mathematical edge. Specifically, Thorp felt that the impact of losses placed a heavy psychological burden on his morale, while gains did not have an equal and opposite boost to his psyche.  Further, he said that he found himself stashing some chips in his pocket so as to avoid letting the casino see them (despite the casino having an idea of how many he had outstanding) and possibly as a way to prevent over-betting.  This is somewhat irrational behavior amidst the quest for rational risk management

As the book Bringing Down the House and the movie 21 memorialized, we all know how well Kelly worked in the gambling context.  But how about when it comes to investing?  In 1974, Thorp started a hedge fund called Princeton/Newport Partners, and deployed the Kelly Criterion on a series of non-correlated wagers. To do this, he used warrants and derivatives in situations where they had deviated from the underlying security’s value.  Each wager was an independent wager, and all other exposures, like betas, currencies and interest rates were hedged to market neutrality. 

Princeton/Newport earned 15.8% annualized over its lifetime, with a 4.3% standard deviation, while the market earned 10.1% annualized with a 17.3% standard deviation (both numbers adjusted for dividends).  The returns were great on an absolute basis, but phenomenal on a risk-adjusted basis.  Over its 230 months of operation, money was made in 227 months, and lost in only 3.  All along, one of Thorp’s primary concerns had been what would happen to performance in an extreme event, yet in the 1987 Crash performance continued apace. 

Thorp spent a little bit of time talking about the team from Long Term Capital Management and described their strategy as the anti-Kelly.  The problem with LTCM, per Thorp, was that the LTCM crew “thought Kelly made no sense.”  The LTCM strategy was based on mean reversion, not capital growth, and most importantly, while Kelly was able to generate returns using no leverage, LTCM was “levering up substantially in order to pick up nickels in front of a bulldozer.”

Towards the end of his talk, Thorp told the story of a young Duke student who read his book called Beat the Dealer, about how to deploy Kelly and make money in the casino.  This young Duke student then ventured out to Las Vegas and made a substantial amount of money.  He then read Thorp’s book Beat the Market and went to UC-Irvine, where he used the Kelly formula in convertible debt to again make good money. Ultimately this young built the world’s largest bond fund—Pacific Investment Management Company (PIMCO).  This man was none other than Bill Gross and Thorp drew the important connection between Gross’ risk management as a money manager and his days in the casino.

During the Q&A, Bill Miller, of Legg Mason fame, asked Thorp an interesting two part question: is it more difficult to get an edge in today’s market? And Did LTCM not know tail risk and/or realize the correlations of their bets?  Thorp said that today the market is no more or less difficult than in year’s past.  As for LTCM, Thorp argued that their largest mistake was in failing to recognize that history was not a good boundary (plus the history LTCM looked at was only post-Depression, not age-old) and that without leverage, LTCM did not have a real edge. This is key—LTCM was merely a strategy to deploy leverage, not one to get an edge in the market.

I had the opportunity to ask Thorp a question and I wanted to focus on the emotional element he referenced from the casino days.  My question was:  upon recognizing the force of emotion upon himself, how did he manage to overcome his human emotional impediments and place complete conviction in his formula and strategy?  His answer was a direct reference to Daniel Kahneman’s Thinking, Fast and Slow, whereby he used his system 2, the slow thinking system, in order to force himself to follow the rules outlined by his formulas and process.  Emotion was a human reaction, but there was no room to afford it the opportunity to hinder the powerful force that is mathematics.

A Kevin Douglas Update

A few commenters have pointed out the extent of the American Superconductor losses, and they are vast: Mr. Douglas has lost somewhere in the neighborhood of $220 million over the past two years in this position.  The loss is real, and absolutely impacts his performance over the past ten years.  That being said, it’s most likely not nearly as bad as the sticker shock number suggests, considering he first purchased the stock in the single digits in 2006, and did sell 20% of his holdings during 2008 and 2009, at prices double what he first paid, before piling back in during 2011.  Have no doubt, I clearly recognize that the man lost a bunch of money on this investment, particularly of late.  Yet still, what is most impressive is that DESPITE the loss in AMSC, his outstanding gains on Monster/Hansen, IMAX and Westport combined are well in excess of his losses in AMSC, and those are just three of his investments. 

Let me further add that I under-calculated his stake in Monster/Hansen in the original post, as the numbers quoted were based on his personal stake, held in his own name, not additional shares purchased for the Douglas Family trusts, and other family members for whom he invests.  The losses in AMSC are reflective of these other beneficial holders as well, and as such, this greater gain helps provide more context to the AMSC loss.  With this new number on MNST, Mr. Douglas’ initial investment in Hansen was closer to $950,000 and total gains were at minimum $120 million, and realistically more like $150 million considering he locked in some profits during the company’s initial surge in 2006.

Further there remain several significant gains that I glanced over for the purposes of this writing.  One substantial gain was his ~14.5% stake in Rural Cellular Corporation, which he accumulated primarily in the single digits, with buys up to $20.  In 2007 the company sold itself to Verizon for $2.67 billion, or $45/share (the deal closed in 2008).  At the very least, he cashed out $387 million on an investment that was no more than $150 million.  I am fairly certain that I am overstating his initial investment in the company, however I cannot track down an old price chart on Rural Cellular in order to more accurately calculate a cost basis.  I only know dates and filings. 

But I digress.  It is unquestionable that Mr. Douglas has made massive amounts of money on his investments, it’s simply impossible to calculate a) how much capital he was working with; b) what his cost basis was in most investments; c) if he made any investments that did not require SEC filings.  For these reasons, building a composite performance number is in my view, unnecessary to understand the magnitude of Mr. Douglas’ gains and his investment track-record.  Further, let me make explicitly clear that my intentions in writing about Mr. Douglas were two-fold: first, to deliver some accolades to a man who unquestionably has built an outstanding track-record; second, and most importantly to me, to share some of the insights I have gained from my attempt to back into his investment thesis for 10 of his investments, 8 of which were successful, one of which is a failure as of today, and another which in my opinion remains to be seen.  There is much to learn from the process Mr. Douglas undertakes, even when presented with a losing outcome on an individual investment.