Always Ask Why | Zach Miller
See the full episode notes HERE
In last week’s AWM Insights, Brandon Averill, Erik Averill and Justin Dyer discussed some of the biggest financial and investment news including DoorDash – a food delivery service– which reached a $60 billion market cap, even though the company isn’t currently profitable. Will it get to profitability? Why are IPOs like this and AirBnB ending up with such unexpectedly huge valuations? Here is a breakdown of the key takeaways and resources from the episode:
"Not politics, not fear, not greed, just math."
Justin Dyer summed up in another conversation how you can target long-term outperformance in such efficient markets as ours: “You create customized active portfolios that are passively implemented to avoid frictions.” You do this in harmony with financial structure and your benchmark is meeting specific client outcomes. The portfolio reduces frictional costs such as unnecessary taxes, high expenses, and avoids sources of return that academically may be proven but in reality cannot be implemented efficiently. Tilting to higher confidence of returns such as the value, size, profitability, term, and credit premiums give the portfolio a better chance of higher expected returns for long-term investors. If you do not understand math, statistics, and probability then at least hire an advisory team that does.
Returns come from taking Risk: The Sources of Return in the Market
Enterprise Risk - access to the public markets through shares of public companies. This includes the equity risk premium as well as other premiums. Small vs Large, Value vs Growth. To a lesser degree High vs Low Profitability and Momentum. Enterprise risk is where the highest confidence of returns can be expected.
Engineered Risk – Leverage, Illiquidity: This can be through margin or other borrowing to increase absolute returns. This also increases risk. There is no free lunch once again. This is where private investments tend to generate the majority of their outperformance versus public markets. As this is just manufactured risk, it has a lower confidence in returns.
Manager Skill – Luck vs Skill, the odds are stacked against these managers. The data shows that managers that outperform are not able to repeat reliably. The data on active managers outperforming their fees is pretty awful usually around 3% above what would be modeled above chance. Good luck guessing right on which managers that will be as persistence of outperformance is so weak. This is a low confidence area to try to outperform.
What to know about all these IPOs
When you buy a company that is unprofitable you must have faith in the business model of the company along with confidence that management will execute at a high level to eventually become profitable. Many people are hoping these unprofitable companies follow the path of Amazon and Tesla to eventually become profitable. The historical record on IPOs is not favorable for investors that buy the stock once it starts trading. The stocks you are most likely to get an allocation of are the stocks that do the worst. The ones that have the best first day, of course, are the hardest to acquire. This has led to general underperformance of the IPO equity relative to their benchmark.
Why?
Why will the stock you want to buy go up? What special knowledge or information do you have that no one else does. What is your investment thesis for why this stock is underpriced. If you have a good answer with relevant expertise then it would be a good discussion to have. Brandon asks the “why” when he hears the popular stock question of the week: "My uncle or my friend bought Tesla and they think it's going to X or Bitcoin's going to X." My response is always like, "Okay, that's great. Why?" Justin expands on this and why it delineates professional investors from amateurs. “The likelihood or the probability of them actually being right on, let's just say Airbnb because that's the hot topic of the day, the probability of them being right on that call is pretty low. Is it certainly a possibility? Yes, no question about it. But then it gets back to something we've highlighted in a couple of other podcasts. Is that really skill or is that just luck?” Are you just guessing and gambling or do you use data and probability to drive decisions. Here is that link to that previous Insights podcast: Focusing on What You Can Control.
Luck or Skill
One of the worst ways an investor can begin investing is to have immediate success because now they will have an overconfidence bias and likey take more risk than they should. Many newer investors have been rewarded for speculating and lack any sort of diversification. This isn’t much of a problem when it is relegated to a tiny portion of a portfolio but that has not always been the case if you read some of the recent news. “But at the end of the day, it does go back to the data and the math. What we know is that a successful outcome as an investor, a long-term investor, in the public markets, and we could go down the path on the private markets, but in the public markets is to be that globally diversified investor that is allocated to the areas of higher expected returns. We've talked about that, small value, profitability, et cetera, but it's not as fun.” What Brandon describes is how allocating toward the assets with expected returns of the highest confidence is how active portfolio management can lead to outperformance. Short-term thinking, relying on getting lucky, and return chasing is not a good strategy for reliable returns. Remove emotions from investing is almost impossible, a better strategy is to acknowledge and “Mute your emotions” when it comes to investing.
Book Recommendation:
Brandon recommends reading Morgan Housel’s Psychology of Money. I echo this recommendation having read it recently myself.
Research worth Reading
“Luck vs Skill in the Cross Section of Mutual Fund Returns” -Eugene F. Fama and Kenneth R. French, Journal of Finance (2010).
“IPO Profiles are High: What about Returns” -Dimensional Fund Advisors
