Trigger happy

Earlier in the year, the folks at Mawer Investment Management published a podcast on why they tend to focus on vulnerabilities and try not to predict triggers for events. About a decade ago, I would have wholeheartedly agreed with their approach, but I want to explain, why my thinking has changed and how.

Before I go into my own thinking about triggers and vulnerabilities, let me make it clear that I like Mawer. I know a couple of people in their Wealth Management business and both the asset management and the wealth management business are excellent, in my view. Plus, they have hands down the world’s best tagline for an investment manager.

Mawer typically follows a value investment style which is why they emphasise their defensive approach to forecasting and their focus on vulnerabilities over triggers. They argue that as human beings, we focus on triggers too much because triggers are specific events that are much more visible and salient to investors than the underlying vulnerabilities.

One example would be banks in 2007/2008. It was well known that after the de-regulation of the 1990s, banks engaged in increasingly risky lending practices. Investors thought that the securitisation of risky mortgages in CDOs would remove the risk from the banks’ balance sheets, but there were quite a few people who realised that banks tended to keep some of that risk temporarily or permanently on their balance sheets. That provided a vulnerability that existed for many years before the crisis, but only when interest rates rose and the housing market in the US collapsed did it trigger the collapse of the banks and a global financial crisis. Reading how Michael Burry had to fight against his own investors for years to maintain his loss-making bets against banks is instructive and one of the best bits in Michael Lewis's book “The Big Short”.

Michael Burry and the other protagonists of The Big Short saw the vulnerabilities in banks and focused on them rather than the actual trigger. They knew they couldn’t predict the trigger but whatever it would be and whenever it would happen, they would make a lot of money from the vulnerabilities of banks at the time.

This approach will almost inevitably lead you to a value investment style because the whole point of value investing is to only invest in assets that have a large enough margin of safety so that if unforeseen things happen, they won’t kill your portfolio.

I agree with that approach in principle. I think most investors are too focused on forecasting triggers and their timing. Being more defensive and realistic about what one can and cannot predict definitely helps with performance. But where my thinking has evolved is that one cannot be too defensive.

The financial crisis has made folk heroes of the protagonists of The Big Short because they recognized vulnerabilities and stuck around until a trigger caused these vulnerabilities to turn into a fully-fledged crisis. But what if the trigger had never materialised? What if the financial crisis had come a couple of years later? To put it another way, for every Michael Burry whose bets against the vulnerabilities of banks worked, how many people were there who bet against these vulnerabilities but couldn’t hold on to these bets long enough? What if Michael Burry could not hold on to his positions long enough and had to abandon them or close his fund before the financial crisis happened? Would we still think of Michael Burry as this genius investor, or would he just be another example of a failed hedge fund manager?

For an investment to work, one needs to have a vulnerability and a trigger. For value investments to work, one needs to have a cheap asset and a revaluation. The revaluation doesn’t happen out of nowhere. And risks don’t materialise just because. They both need a trigger or a catalyst so that investors or Mr Market start to re-assess the asset.

Without that trigger, investors will be sitting on a loss-making or at least underperforming asset for a very long time. And in the worst case that underperformance can continue for such a long time that even if the trigger finally materialises and their bet pays off, it won’t pay off nearly enough to make up for the years of losses or underperformance. It would have been better to just ignore the vulnerability and go along with the ignorant market.

In the summer, I published my series against Cassandras and if you look through that list, one common thread is that most Cassandras have identified true vulnerabilities in financial markets. Yes, the Euro is vulnerable because there is no common European fiscal policy. Yes, the bond market is vulnerable because there is too much debt and the eternal lack of fiscal discipline by governments leads to persistent budget deficits. However, these vulnerabilities have existed for a long time and have been pointed out by investors for almost as long.

How did people who bet on a breakup of the Euro fare in the past decade? How did investors who bet on a default of the US perform so far? These people may argue we just have to wait, but that is my point. As I have shown in my discussion of the performance of Cassandras, you have to get the timing of your investments right in order to make more money from betting on vulnerabilities than just going along and investing in the market all the time.

All that is to say that in order to be a successful active investor and beat the market, you need to look at vulnerabilities and triggers. Yes, you don’t have to predict the nature and timing of a trigger event – that is impossible anyway. But you do need to have a good grasp of what kind of trigger could expose the vulnerability and under what circumstances this trigger could materialise.

Investing in a vulnerability that has, say, a 1% chance of materialising is not going to make you a lot of money, even if your payoff is an extreme ten-bagger because to hold that investment you incur costs (in the form of losses or missed returns vs. the market) while you wait for the vulnerability to materialise. Typically, you need to have a hundred-bagger or better to break even when you invest in a vulnerability with a 1% chance of materialising at any given time. And there are very few investments out there that are true hundred-baggers in reaction to a specific event. This investment is also subject to another behavioural bias. We all tend to overestimate the likelihood of extremely unlikely events. If a vulnerability has a true chance of materialising of one-in-hundred, humans tend to put a subjective probability or something like one-in-twenty or 5% on this event happening. We think rare events are much more common than they truly are and that gets us into all kinds of trouble.

So, what is one supposed to do? I would say that being defensive with your predictions is a virtue, but being too defensive is not. I tend to think of vulnerabilities and triggers alike, but I only take vulnerabilities seriously when I can see a trigger that has a decent chance of materialising within a reasonable time. Next week, I will provide you with a simple numerical example to show you what I mean by that. For now, let’s just leave it at that and emphasise that a vulnerability without a trigger is a vulnerability for the investor, not for the market.