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Tom Seto – Parametric Portfolio Manager

by James on April 28, 2011


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I just spoke with Tom Seto, Managing Director of Parametric Portfolio Advisors.  Parametric manages nearly $40B in client assets.  It focuses on buy-side asset management. The investment strategy is a statistical quant driven model that is essentially the polar opposite of fundamental analysis.  Its strategy is more along the lines of modern portfolio theory (MPT) in which it maximizes portfolio return and minimizes risk buy holding various assets chosen from its back tested quant models.

Parametric does not aim to beat the market, but to achieve client specific objectives such as lowering tax liability, variance, and volatility.  Parametric has a unique business model and has had spectacular growth in recent years.  When Tom joined Parametric they managed only $2B, which was a small in the investment world.  Today it manages $40B and assets under management (AUM) continue to grow.

Tom graduated from the University of Washington with a degree in electrical engineering.  After a career as an engineer he decided to change his career path and got his MBA from the University of Chicago.  After graduating he worked at Barclay’s Global Investment for seven years before it was bought out by the behemoth Blackrock. He was on senior leadership but decided to take an opportunity at Parametric which allowed him to go back to Seattle, a city where he always wanted to end up.

Efficient Market Hypothesis

Tom was groomed in the efficient market hypothesis, a dominant market ideology from Chicago.  For the most part, he agrees with the efficient market hypothesis and believes it’s extremely hard, if not impossible to beat the market consistently.  This suits Parametric’s business model well as its products seek to track specific market segments.

Capital Flow Trend

Interestingly, one of Parametric’s many successes is its Emerging Markets portfolio which has outperformed the market by 1% to 2% annually.  While this seems marginal, it is a tremendous feat when managing billions of dollars with low variance and volatility targets.  This performance is especially attractive to institutional money as clients with hundreds of millions of dollars are seeking beta (broad market exposure) and low risk as measured by variance.

Market Anomalies

Berkshire’s huge success has to do with not only good stock picking, but also favorable market conditions since 1965. Recall: A rising tide lifts all boats.  While Buffett had the advantage of roaring stock markets, he also achieved alpha by returning 20.2% annually compared 9.4% for the S&P 500.   So of course I had to ask Tom: “If markets are efficient, how do you explain Berkshire’s outstanding performance.”  Tom replied:

Imagine you have a thousand money managers with a thousand different strategies. By the law of distribution there has to be some that do exceptionally well and some that do exceptionally bad. It does not have to do with how “smart” the manager is, but it has more to do with the fact that he was lucky and perhaps incidentally chose a strategy that worked. For every 10 to 20 managers that do exceptionally well such as the SAC Capital and Bridgewater Associates, there are hundreds (if not thousands) of others that don’t.

So why try?

While I agree with the outcomes of the argument – some do exceptionally well, most don’t – I disagree with the reasoning.  Take basketball.  A small portion of basketball players make it to the NBA.  Many play basketball, but most are average.  Only the exceptional ones make it to pro basketball – say, one if thousands if not millions.  This distribution not only looks similar to the success in money management, but the reasons for the outcomes are similar as well.  Those who make it into the NBA possess exceptional skill and those who succeed in money management likewise possess exceptional skill.

That said, this is an ongoing debate about investments between academics and practitioners.  One camp believes its impossible to beat the market and thus no effort needs to be expended.  The other believes that they have the “secret sauce”.  As for the latter is concerned, they play a game where opponents think effort is inconsequential.

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Gary Furukawa – Chief Investment Officer of Freestone Capital Management

by James on April 20, 2011


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I haven’t posted in the last couple weeks as I’ve been meeting with different money managers in the Seattle area but I want to make sure I write about my 45 minute call with Gary Furukawa.

A brief background – Gary Furukawa is the co-founder of Freestone Capital Management an investment firm based in Seattle that has $2 billion assets under management (AUM).  Gary founded the firm in 1999 and ran the company as President and Chief Investment Officer until he relinquished (if I recall) the role in 2007.  Prior to Freestone he graduated as Magna Cum Laude from the University of Washington and worked at Solomon Smith Barney for 11 years where he managed $500 million in client assets.

Needless to say, he has a wealth of experience and knowledge.  The primary question I had for him was: What does it take to become successful in the investment industry.   Gary is a no bullshit guy and shoots you straight (something I appreciate and always try to improve).

He distilled it into two criteria:

  1. Instinct
  2. A nose for opportunity

Instinct – According to him, in the upper echelons of success in money management, either you got it or you don’t.  The “instinct” for investments can’t be taught.  All the schooling and training in the world can’t give you what it takes to be a truly exceptional money manager.

However, in my opinion this begs the question, “How did the instinct originate? Where did it come from?”  Blink: The Power of Thinking Without Thinking by Malcolm Gladwell discusses the art of thin slicing and essentially how instinct trumps the “rational” approach to making decisions.  Instinct is actually acquired – knowingly or unknowingly – by individuals that are experts in a field through time and experience.  For example, a particular tennis coach can call a fault with 95% accuracy when the ball is in the air before the server hits.  First, the ability seems bizarre to say the least.  But second, as bizarre and supernatural as it may seem, this skill was acquired through time.  Perhaps through 10,000+ hours of teaching tennis, and years and years of watching serves.

Personally, I believe instinct plays a huge role, but whether it can be acquired through time is subject to debate.

A nose for opportunity – I believe this follows closely to his first point about instinct.  The idea of buying a dollar bill for pennies appeals to people or it doesn’t.  Some people just “get it” while others are “ho hum”.  Certain individuals have the knack for spotting opportunities and acting on them.  It’s something hard – if not impossible – to teach an individual.

My follow on question for Gary was, “Well, where does the margin of safety and risk management come into play?” After all, the concept of margin of safety is an established tenet for value investors.  From Gary’s perspective, if you have the first two right (the instinct and nose for opportunity) risk management will follow.  At the outset this seems ludicrous especially if you consider the huge market for risk analysis, but then again, crowds don’t define right and wrong.  You’re either right because you’re right, or wrong because you’re wrong – not because people believe otherwise.

If you consider his statement in the context of buying undervalued assets his statement holds.  Good instincts and the ability to recognize opportunity tend to bring the attendant margin of safety.  A good deal should scream at you when you see it.  If you have to debate whether the $100 perfume bottle is a good deal, it’s probably not.

There you have it – the hallmarks of a great money manager according to Gary Furukawa.

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Margin of Safety by Seth Klarman – "Value, Value, Value"

by James on March 16, 2011


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Why does value matter?

When it comes to value investing determining value is 80% of the battle.  Knowing the value of a business requires (1) deep knowledge of the industry and (2) a framework to determine value. Just because you know Apple will sell more iPads this year than last is not enough to determine the value of the company which is heavily dependent on income.  While you might reasonably predict that revenues for Apple will increase, and growth will come from certain segments, it is much more difficult to predict what will happen to income.  Income depends on many factors.  How will their bargaining power with suppliers be affect profit? What will competitors do that may influence Apple’s competitive position for better or worse?  Will the company maintain pricing power with respect to inputs (costs)?  Will the company continue to innovate and forever stay ahead of the curve?

Valuing a business, therefore, requires a solid understanding of the company, industry, and factors that may affect it.  That is why it’s imperative to know your boundaries and limitations – and especially when you’re getting close to it.  Knowing what the general population knows isn’t enough.  You must dig deeper and hone your understanding of the business.

In Margin of Safety, Seth Klarman presents four methods for determining value, all of which have their advantages and disadvantages.  In some cases, using more than method might be the best solution.

1. Net Present Value (NPV)

This is probably the most widely used metric to determine value.  This is a concept that everyone in business school and the finance industry learns.  Adding up all the predicted cash flows and discounting back to today’s dollars using the appropriate discount rate - usually the prevailing market rate.  For example, to determine the value of the bond today, you would estimate all the future interest payments and the principal return when the note is due and apply the appropriate discount rate.  The number yielded will give you the net present value (or price) of the bond.

The same method can be applied to an enterprise.  If future cash flows can be precisely determined, NPV would be the best method of valuation.  While it makes sense in theory, in practice businesses never have earnings as consistent as that of a bond.  Nonetheless, for businesses with consistent earnings and which you believe will continue to maintain their earnings power you can assume the earnings will roughly be the same.  To protect against the unpredictability of the future such as earnings volatility, exogenous events, industry deterioration, you should build in a margin of safety to protect against this. No matter how good you are at analyzing a company you can never be precise about values nor predict the future.  The only guard you have against events out of your control is to require a margin of safety.  The more uncertainty you deem an investment, the larger the margin of safety you must require.

2. Liquidation value

Liquidation value is the rock-bottom value of a company.  Generally, companies in liquidation rarely obtain top dollar for their assets.  Rather, they tend to sell out at clearance prices to buyers that get a bargain.  For example, Circuit City liquidating 10,000 laptops in two days is going to receive much less than Best Buy would if Best Buy were selling the same 10,000 laptops during their regular course of business.  In addition to the extenuating circumstances of liquidation values, it does not take into account going concern value – i.e., value of the company if it were operating.

A quick hand method that can serve as a proxy for liquidation value is the net current asset value.  This takes the company’s current assets (assets turned into cash in less than a year) such as accounts receivable, inventory, marketable securities and nets current liabilities (monies due in less than a year) such as accounts payable and short term notes.

Another more conservative method is the net net current asset value.   This approach takes current assets and deducts all liabilities both current and long term.  This will yield a bare minimum value of the business since the long term assets such as property, plant, and equipment are not taken into consideration.  Generally, if you can purchase a company for less than the net net current asset value you will receive a good margin of safety.

3. Private party transactions

This method values a business based on what a private party would be willing to pay for the whole company.  For example, Company X makes IT components and current earns $50,000 per year.  The market is very optimistic about its prospects and is generally willing to pay a premium in the stock market for this property at forty times earnings.  This will give Company X a market cap of $2,000,000.

Now, would a private party be willing to pay as lofty a price as general market?  Generally the idea is, no.  People purchasing whole business tend to be more realistic than those who purchase pieces of paper (stock certificates) on the internet.

Clearly, there are flaws in this method.  Private parties have and do overpay for business which is why this is a metric that should be used in conjunction with other methods.  

In any event, this serves as another method to measure value.

4. Stock market value

Probably one of the least reliable methods subject to supply and demand in the market.  General price movements in the market are usually caused by investor sentiment as opposed to the fundamentals of the business.

However, when valuing some assets such as closed-end mutual funds or trust companies that have assets consisting almost completely of marketable securities, the stock market valuation is likely the best and only method of valuation.

There you have it.  Four methods to valuation that Seth Klarman and many other value investors use to buy or sell securities.  While, descriptions for the methods above are not meant to make you an “analyst”, it gives you an idea of what value investors are looking for.

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The Common Denominator of Success by Albert Gray

by James on March 9, 2011


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I just met with Bill Borland who is currently a pastor of New Community Church who was recently Managing Director of  Russell Investments.  His background is quite impressive and was even mentored by the CEO of Russell.  He suggested I read The Common Denominator of Success by Albert Gray.

I don’t know much about Gray, aside from what I’ve just read from the article above.  However, it is clear that Gray has caught on to the key determining factor of success and has distilled it into one sentence:

“The common denominator of success – the secret of success of every man who has ever been successful – lies in the fact that he formed the habit of doing things that failures don’t like to do.”

The foregoing sentence in one stroke has captured so much.  Think about all the things worth having in life.  Regardless of whether it is wealth, health, spiritual, social, or physical goals, the line of demarcation for those who achieve their goals and don’t is the ability to form a habit out of things others don’t like to do.

This hits home to me, the blogger.  For those who blog, every blog is a test of stamina and fortitude. My forte is not writing, although I love communication, but even if you are a writer I figure the hardest part of that is writing (i.e., overcoming writers bloc, etc.).  In many cases people fail to achieve their goals because they never stick with it in the tough times to see their vision through.

Take it from a Pastor

This whole thing came to mind when Bill brought up the challenge of delivering a message on Sunday.  For him, meditating and writing the message is not the hardest part, but rehearsing it is.  He believes it easiest for pastors to be remiss when it comes to practicing the message.

As a result, he usually rehearses the message straight through at least six times and doubles up on the beginning and ending.  So a minimum of twelve times for the opening and the closing which he deems the most important part of the message.  Additionally, special attention is paid to the closing where the delivery needs to come from the heart to drive the point home.

He’s only been a pastor for a relatively short period of time (a few years or so), but he’s forming a habit out of things preachers don’t like to do (I’m sure the list goes on).  I trust his messages will do what it was intended to do and the carefully prepared and rehearsed messages will have a strong impact on its listeners and change some lives along the way.

What it Means for the Investors

Every investment requires diligence and homework.  The starting point for securities is reading the annual report and studying financials.  If you’ve ever read an annual report they tend to be 100 to 300 pages long and can put you to sleep.  But if you want to be a serious investor there is no shortcut.  While I couldn’t find exactly where I read it in a great book on financials by L.J. Rittenhouse, something like 70% of stock buyers don’t read the annual shareholders’ letter and 90% don’t read annual reports.

These are the starting points of stock investing yet the vast majority of people cannot even claim to do this.  The reason is twofold: either they are too busy to do this or they have delegated this to someone else (more on this in later posts).

Reading private placements, operating agreements, deeds of trust is part and parcel to invest in bonds, but many investors and money managers just rely on rating agencies’ seal of approval as their due diligence.  And we all know where that has lead us since 2007.

To call yourself an investor you must put in the hard work.  You have to study the industry and have a deep understanding of the business.  Not surprisingly, some have made it a business to love doing the analysis that others hate and that’s exactly why they succeed at it.

What this Means for the Initiated

You need to form good habits, but not just any habits.  In particular, focus on habits that tend to be most rewarding which are habits that other people don’t like.  For example, if you like basketball, you’ll like to be on the court.  Great, most players do.  However, do you like basketball when it comes to drills and conditioning?  Many will say that’s not the part they look forward to most.  But here is where you can really standout and make a difference.

Gray said, “Men form habits, and habits form futures.”  What habits do you have and where where are they leading you?

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Margin of Safety by Seth Klarman (Part I)

by James on March 4, 2011


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Margin of Safety by Seth KlarmanI recently read a book called Margin of Safety by Seth Klarman.  It was referred to me by a director of Blackrock when we met at Blackrock Alternative Advisors’ (BAA) downtown offices in Seattle.  Prior to meeting with Jeff I had never heard of Seth Klarman.  Not surprisingly, it is one of the suggesting readings at Columbia’s Value Investing course.

For the record, when I looked at this book on Amazon a few weeks ago it was selling for $1500!  It has since dropped to $500 for those of you who wish to buy it.

I finished the book while in New York and really enjoyed it.  The book is broken down into three parts:

I. Where Most Investors Stumble
II. A Value-Investment Philosophy
II The Value-Investment Process

In many ways, the book is akin to The Intelligent Investor and uses many of Ben Graham’s principals such as “Mr. Market” and the margin of safety.  Like many successful investors, Seth Klarman is clearly part of the Graham and Dodd circle.

In the ensuing posts, I will write about nuggets of value I got from the book.

Performance Derby

Klarman writes extensively about the “performance derby”, essentially, the goal of mutual funds and institutional investors focusing on relative performance instead of absolute performance.  Whenever you hear how an investment class or fund is performing relative to the S&P 500, that’s an example of relative performance.  It’s how an investment compares to the broader market.

Benchmarking is common practice and is frequent used as a yardstick for quick comparisons.  However, it is not without its drawbacks.  Investment managers that try to beat the market quarterly or annually are short term focused.  Of course they want to beat the market, but more importantly, they don’t want to under perform the market.  After all, to stand out of the pack and under perform the market in just one year is a terrible thing – even if their average return is higher than that over the market for 10 years.

With this short term performance derby orientation, investment managers are likely to sell investments that are in fact good buys and buy stocks that are performing well and in favor to not miss the ride.

This provides value investors with great opportunity to buy undervalued stocks at even a cheaper basis.  This is exactly why you have the excesses on the sell and buy side.

How to Define Risk

Many finance professors and investment professionals define risk as volatility. Volatility (also known as “beta” at universities) is the tendency for the stock to fluctuate more or less in relation to the market. The more a stock fluctuates in relation to the market, the higher risk and vice versa.

Klarman in very simple terms defines risk by two components:

  1. The probability of loss
  2. The potential amount of loss

It’s amazing how sometimes you can over complicate the simplest things in life (and investments).  Essentially, when thinking about risk you can reduce it to those two components.  Of course this assumes that you don’t have unique liquidity needs.

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The Intelligent Investor is Back

by James on March 2, 2011


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To all my readers, I sincerely apologize for not keeping up with my blog. It’s been nearly seven months since I’ve blogged. Much of it was motivated by financial and time constraints: blogs usually don’t pay the mortgage and there are only 24 hours in a day.

So, I’m going to make a commitment and try to blog a couple times per week. Since it’s been a while, after receiving my first update you can unsubscribe if you wish – there will be no hard feelings. These updates will keep coming so if you wish to jump ship, do it now.

For writers, this goes without saying, but writing really does take a lot from you. You must plan for it, you must do it, and you must deal with the consequences of it – through feedback that is good or bad.

My goal for resurrecting this blog is twofold:

1. To organize my thoughts on investments and flesh out investment topics and ideas more formally.
2. To hopefully educate and add value to those interested in the topic of investing, personal development, and personal finance. However, I think for at least the near term, it will be “investment” heavy.

I’ve recently come back from my visit to Columbia University and purchased nearly all the books they had on Value Investing. For those of you who don’t already know, Benjamin Graham, widely known as the Father of Security Analysis graduated from Columbia and subsequently taught classes on Security Analysis there. Graham also later came to be known as Warren Buffett’s mentor.

In the ensuing months I will start writing about my readings and interviews, if any, from knowledgeable professionals in the industry. This Friday, I am tentatively scheduled for a call with Joshua Siegal, adjunct professor of Columbia University, who is the co-founder and Managing Principal of StoneCastle Partners which manages more than $2.6 B in assets predominately concentrated in the financial sector.  I’ve asked his permission to post our call on the blog and I’m waiting to hear back.

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How to Feel Financially Free

by James on August 10, 2010


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It is no surprise that the number one reason for divorce is money.  Furthermore, it is no surprise your placement in society’s totem pole is dictated by how much you make than any other factor – education, popularity, faith, morals, or good looks (sorry to spoil your day).  A stroll through today’s news will show that “newsworthy” people incidentally make a lot of money or they’re worth a lot of money. And if you’re not worth big bucks, knowing someone with money is just as good, think HBO’s Entourage. If you haven’t watched the show, it’s a series about Vincent Chase (starring Adrian Grenier) who hits it big in the movie industry and takes his entourage along for the ride.

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How Jesus Would Choose a Fund or Money Manager

by James on July 26, 2010


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You’ve all heard of the phrase, “Let your money work for you.” If you’ve saved up enough money and amassed sizable savings, you might be thinking: Where should I invest my money?  While you can invest in stocks or bonds, another alternative is investing in funds.  Funds are typically run by money managers and can be public or private.  Different funds have different risk/return proportions and lockup periods where the fund requires you to invest for a minimum amount of time (months or years).

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How to Buy a Short Sale – or a Foreclosure in King County

by James on June 21, 2010


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How to Buy a Short Sale – or a Foreclosure in King County

It’s been a while since I’ve blogged and I apologize for that.  My recent preoccupation with an investment property is to blame.  I’ve been in contract to purchase a short sale in Madison Valley and the negotiators are working with the bank to get final approval before the property goes to auction this Friday.  Meanwhile, I thought it’d be nice to share the process as it’s fresh in my mind, and perhaps you will glean something from it for your next real estate investment project.

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Magic Formula Investing – In 3 Steps

by James on June 11, 2010


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Book Review: The Little Book that Beats the Market

What if you heard there was a “Magic Formula” that said you can beat the market.  You were told that the little guy has a chance to outperform stock market analyst and portfolio managers?  No need to just invest in index funds and wait mindlessly while your investment grows (or diminishes).

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