Play to win. Repeat.
Everybody likes to win. It is in our nature. The rush caused by winning is prodigious, especially if the winnings are significant. We either win due to luck or skill, or a combination of the two. Usually, when skills are equal amongst players, luck plays the deciding factor. Winning by sheer luck is satisfactory but poses an immediate challenge to the winner: “Can I repeat my win? Is this possible?”. Winning because of skill is much more satisfactory than winning thanks to luck, but also poses an immediate challenge: “How do I keep ahead of my nearest competition? How do I improve my skills? Is it even possible to win again and again and again and….?”
Anyone interested in winning should familiarize oneself with statistics and expected values. Would you accept a bet to invest all your assets with a 99% odd to win? Yes, me too. But now consider you have to keep playing... Would you accept to play again and again? No way. You are certainly going to lose it all once you hit that 1%. It is 100% certain. You can quickly see how much more difficult it gets to figure out the odds of a win and the value of your expected winnings when we introduce time, frequency, dependability, and second or higher dependabilities next to skill and luck. It is a game well played by mathematicians, crooked geniuses, and the herd. More on this later… and, yes, I will give you my two cents on where we are in the current environment at the end.
Stock market and sports betting
Some of the best minds in the world are attracted to the winnings of financial markets and sports betting. The best minds are competing with speculators and gamblers, all intrigued by unlocking the secrets of the repeated win. Some of you might have read the great novels written by James Clavell which take place in Hong Kong and address its dealing and wheeling in power: Tai-Pan and Noble House. These novels draw a parallel, between business bets and sports gambling with a major role reserved for the Hong Kong Jockey Club which offers bets on horse races. Since 1884, fortunes have been won and lost in Hong Kong and the Triple Crown horse race remains one of the main gambling events today.
A hundred years later, along came Bill Benter, a mathematical talent and physics major from Pittsburg, Pennsylvania. Bill Benter used his formidable skills to learn how to win from the casinos, playing poker and blackjack, and eventually at the horse races in Hong Kong. Nobody thought you could consistently win at horse races: there were simply too many variables and, to keep on playing, you need to avoid the gambler's ruin, i.e. losing all your chips and going broke. Bill started small and used increasingly sophisticated algorithms with factors such as the weather, number of rest days, and types of horse feed to gain a minuscule advantage over the prevailing betting odds. By combining a very small edge and placing many bets, he was able to edge out a winning strategy. Bill improved his algorithms and increased the datasets that were feeding them. He found out meteorologists in a small place in England kept a detailed archive of the weather in Hong Kong dating back many years. Wind and rain play a small but significant role in speed. Bill Benter digitized all the data and integrated it into his model, which ended up with more than 120 factors. By placing more than 51,000 small combination bets, he was able to win the Triple Crown (all three horse races). Bill actually never collected his prize (HK$118 million), although he is rumored to have won and collected in excess of US$1 billion through betting on horse races prior to this major win. Bill is now a visiting professor and a fellow at the Royal Statistical Society. He is the first man that could be seen as running a factor-driven quant hedge fund albeit on horse races. By the way, Bill Benter knows very little about horses.
Of course, you are not betting on horses or gambling your assets on the March Madness basketball pool. You are investing your money (thoughtfully) in the stock market and on that note, along came Jim Simons, a Mathematician who graduated from MIT at the age of 23, a Cold War code breaker working for the NSA and a person who solved an unbreakable math problem. He is also the founder of Renaissance Capital, the most successful investor known to financial markets. Yes, you got that right, he is an enigma on two legs. Jim yearned for independence and figured he could achieve it through gaining personal wealth. The financial markets seemed the shortest way to get there. Nobody thinks you can consistently win big in the stock market: the system is just too complex with too many variables.
Just as Bill Benter’s success took years of hard work and endless tinkering with cleaned datasets, it took Jim many years and the help of numerous Ph.D. 's in Mathematics to finally crack the market. Jim figured he was not interested in the “Why’s”; Jim was just interested in correlations between price movements and the reversion to the mean. In short, every price movement that shows an anomaly will eventually return to its mean value. Jim and his team, like Bill Benter, worked tirelessly for years to gather as much clean data as possible to feed into his algorithms. Most investors look only at the opening or closing prices for backtesting. Jim Simons and his team split the trading days into small time-fragments and use supercomputers to look for dependable signals that might indicate a reversal to a mean from any anomaly seen in price point data ranges. Monday morning trading differs in sentiment from a Friday afternoon, just like judges tend to give more lenient sentences just after lunch rather than early in the morning. Arbitraging the sentiment by buying late Friday afternoon and selling at the open on Monday is just one example of arbitrage. It turns out that human behavior is mostly uniform and can be used to find many small ways to profit from, as long as there is a dependable relationship. Why this happens does not matter to Renaissance Capital.
By being right slightly more than being wrong (50.75%) and by placing many trades (300,000 trades per day), in combination with huge leverage (12.5 x equity), Renaissance Capital can edge out a seemingly endless stream of enormous profits. To find anomalies, Renaissance Capital deploys multiple supercomputers with teraflops of power using datasets that are larger than multiple petabytes of memory. No competitor has come close to this, although there are a few who are getting closer. What can your MacBook do?
Until 2019, Renaissance Capital’s Medallion fund returned more than 66% per annum since 1988. Do you still call this competition? Oh yes, I forgot to tell you the Medallion fund is for employees of Renaissance Capital only. What Jim does is called statistical arbitrage, a field that is played by supercomputers, super-fast connections (keep an eye on Elon Musk’s Starlink), a lot of mad science with gifted scientists looking for causal correlations in just about everything. Jim has amassed a personal fortune of 23 billion US Dollars and made many of his partners and employees very wealthy in the process. By the way, many Renaissance Capital employees know little about the companies they invest in.
So how do we feel, like winners I bet?
Let’s continue and see who else is not playing the fundamental economics game of investing but is competing with us for a repeated win. Ah yes, the genius fraudsters. The smooth-talking people who fly too close to the sun, but appear immune to its heat for way too long but eventually almost always end up going down in torrid flames taking our money with them. Charles Ponzi, Ivar Kreuger, Bernard Madoff, Bre-X, Enron, Theranos, Luckin Coffee, Wirecard and many many many more. What is up with all these frauds?
Winning surely invites taking shortcuts. It is just in our nature. There are the ones who start with a small lie and irreversibly go down the wrong rabbit hole, and then there are the ones who are fundamentally crooked from the start. Ivar Kreuger, the Match King, is a special story and the biggest in the financial markets. I recommend reading the book by the same name. It is the fascinating story of a financial genius, a striver for ever more wealth, a super smooth manipulator of human biases. But, it is also the story of enablers (banks, auditors, tax advisors), the willing persons who aid and abet fraud for personal winnings without any moral considerations for the consequences at large.
Ivar Kreuger inherited a cash cow from his father in the form of a match manufacturer, which, after he consolidated the market, had a monopoly in Sweden and became known as Swedish Match. Ivar’s master plan was to lend money to foreign governments at attractive rates in return for a monopoly concession in match manufacturing and distribution in those countries. The money to be lent to foreign countries was raised in the USA by Lee Higginson, a New York-based Investment Bank selling International Match Co. debt securities (a newly formed company) to its clients. France, Germany, Poland, and many other countries entered into a contract with Ivar Kreuger, and investors in the USA were blinded by the promised high interest rates they could earn.
Ivar was able to put together very innovative financial transactions (convertible bonds, preferred shares, voting shares, currency options) and ended up with a network of c. 200 companies. Ivar smartly transferred assets between these companies in order to double-count them and use them as collateral against ever-increasing liabilities. Ivar also forged millions of Italian government bonds to be used as collateral (much like the copper golden bars of the NASDAQ-listed King Gold Jewelry used as collateral). Ivar Kreuger also owned Ericsson and many other very profitable businesses, but in the end, when prices came crashing down during the 1933 depression, the fraudulent over-leveraged balance sheets were discovered and as always the unraveling of many reputations came brutally quick.
The Kreuger case ended up in a string of new laws and requirements for listed companies in the USA. Swedish Match still exists and you can still buy its shares. So does Ericsson, which is now one of few 5G network providers in the world. The New York Investment Bank that helped International Match Co. raise all the cash for the loans went bankrupt just like Kreuger & Toll, taking many investors down with them.
As in many of these cases, a healthy dose of common sense would have prevented disaster. Clues, like overly defensive and/or fear-inducing behavior by a CEO, a weak Board of Directors, high-profile investors, complex financial structures, sales too good to be true, the pressure to maintain growth at all cost, weak auditors and greedy investors who soak up the narrative like kegs of Kool-aid, are all signs it might be time to chill and let somebody else take the “win”. Look around and you will find some stories that could fit the description, caveat emptor. When fraud is finally discovered, multiple billions of dollars usually go up in smoke in a matter of seconds. Capital destruction is permanent.
So how do you feel now? Ready to continue? Still feeling that repeated win?
Yes, so let’s continue. We are almost there. The last hurdle of competition is ourselves. Yes, you heard it: we are walking obstacles obstructing our own repeated wins. Our behavioral biases are well documented, but the fact that we cannot help ourselves to change or to avoid them is not. How is it possible to know your weaknesses but to be unable to act upon it? It is a mystery locked into our genes and something we might be able to change with CRISPR in the future? Regardless, for now, we have to live with it and control our biases as much as possible. At i-Cthru, we have eliminated most of them by automating decision-making into algorithms. It helps us every time we have to make an investment decision.
When the oil price collapsed to $8 during the ongoing COVID-19 crisis, many investors jumped at the chance to invest through an oil ETF. Many invested $1,000 or mere multiples of that. The ETF manager was forced to sell at negative prices because it was exposed to timely contracts to physically take delivery of oil with no place to store it… One big player made $5 billion dollars in one day, the rest of us lost. Yes, that is only 5 million people investing $1,000 each and not reading the fine print. I know, it wasn’t you.
The Truth II
I am going to partially repeat what I said in my last blog. We, at i-Cthru, don’t have all the answers: there are simply too many variables at play to make an educated guess at this point. Although one of our partners is a mathematician, we are not Renaissance Capital. We know our limits and therefore simply revert to what we know best, which is protecting assets in the best way possible. We do this by concentrating on value not price, holding a lot of cash in uncertain times, acting like business owners of the companies we own, letting our automated strategy do its work without any emotional biases, including greed, getting in the way of a sound investment decision and buying protection against further calamities if available at the right price. The competition for our repeated wins is fierce, but we think we have a couple of advantages. We have patience and invest with a long term horizon. We have unbiased algorithms based on fundamental factors. We have trading algorithms designed to actually slow down our trading so flash- or high-frequency trades fly mostly past us. We read a lot, but it is hardly the daily news that makes us trade. The daily news does make us shake our heads quite a lot but we stay focused on long-term profitable trends.
You see, it does not make a lot of sense for us to exert a huge amount of energy to chase maximum performance for a short period, just to lose it all in a few days. If you are a long-term investor and you don’t need cash, the coming weeks/months will be easier, because you won’t have to navigate the short-term volatility of the markets. You can simply concentrate on the businesses you want to own for the next 10 years. If you liked them at a certain price, you should like them even more at a discounted price.
We do see a few things we would like to share with you. Only 500 US hedge funds out of 11,000 consistently make money. Retail investors seem to have the momentum and retail account openings are reaching feverish heights. Success and easy wins are powerful incentives and invite more retail investors to also pursue an easy win.
Individual and corporate taxes are very likely to go up almost everywhere, but especially in the USA. Leverage is up and so are debt service payments in spite of low interest rates, which all point to lower profitability at the corporate level.
We know extremely little about the virus and therefore about the second or higher degrees of effects on companies’ earnings and people’s (spending) behavior. The real risks are the risks we don’t see. We, at i-Cthru, will remain cautious and think the current risk/reward ratio is not in favor of repeated wins and being aggressively invested. Remember the gambler’s ruin: we will avoid this at all costs.
We did make small investments with very significant expected values in our China and Workflow themes. Although some investments like DocuSign (up 86% in Q2, 333% since IPO) and Blackline (up 53% in Q2) might have run too far ahead of their fundamentals, we will treat them and our other qualitative investments as a farm which does not print its sales price every day. We see long runways for the companies we selected in our qualitative portfolio and patience remains a substantial competitive advantage for us. We aim to keep it.
We thank our clients for their trust in us. It is an enormous responsibility and we will try our utmost best not to disappoint you. Be safe, be patient, salute our heroes, read good books, and be optimistic: it pays!
Let us know your investment story; we would love to hear it.