Author: CJ Brott, Capital Ideas
Disclosure: Long DVN
I recently read a client letter by Barton Biggs that was very enlightening. Mr. Biggs and I are both macro investors and have both been investing professionally for over 40 years. So much of what he had to say sounded very familiar. The gist of his thinking deals with the two battles all investment managers fight: understanding the investment process and understanding themselves.
In this client letter he dispenses quickly with the investing process itself, instead focusing on a detailed discussion of the destructive power market swings have on a manager’s investment psychology.
He describes briefly the ongoing battle to hold long term positions in an increasingly volatile market and ends with a warning about the value of understanding the effect of one’s emotions on their actions.
The most important takeaway is that investment psychology has never been more important. In today’s world central banking credit policies are creating an atmosphere far more prone to bubbles and panics than any time in our investment careers.
Combine the extreme volatility created by momentum traders with client focus on short term results and any manager focused on value or the longer term will occasionally question his own sanity.
This is where deep understanding and certainty of your investment thesis and the facts it is based on triumph over panic or euphoria. Our current portfolios contain several examples of this type of investment circumstance, one where our sanity may be brought into question.
Our macro portfolio contains Radio Shack (RSH). This may be one of the most hated stocks on Wall Street. Currently the short term momentum traders seem to feel it can only go lower. As a result, they have established a short position of a size large enough that the stock has become difficult to borrow.
With plenty of free cash flow, a current dividend of $0.50 per year, and an expansion plan both here and in Asia, and Radio Shack may yet work out of their problems. Although owning it will bring a manager many a derisive comment, the stock seems to represent decent value with a better than even chance to turn itself around.
Another controversial idea is the process of “fracking” as it pertains to oil and gas exploration. Applying it as a macro idea we bought two stocks, Devon Energy (DVN) and Chesapeake Granite Wash Trust (CHKR). While we still hold Devon, believing it to be worth much more, we sold CHKR as it exceeded what we believed to be its fair value.
This is another example of psychological control. While momentum traders drove Chesapeake Granite quickly from $18.50 to $30.24 it would have been easy to succumb to the euphoria and fail to liquidate the stock.
However part of the investment process is the constant reexamination of one’s investment thesis. Upon continuing examination of the CHKR hedge positions it became apparent that I was wrong to continue holding the stock.
This is a great example of the investment process helping control the psychological urge to become euphoric as investment ideas work out. And it is that fundamental examination which allows me to keep Devon Energy, despite the popular idea that natural gas prices will decline forever.
Obviously, I was impressed with the discussion of the psychological aspects of investing Mr. Biggs included in his recent client letter. He is right: The pressure to give up and join the crowd during these volatile times is immense. Central banks will continue to increase credit, increasing the probability of higher economic and market volatility.
In this new world knowledge gained from experience will be invaluable. And that knowledge is not just the ability to analyze securities and understand economies but knowledge of your own psychological strengths and weaknesses. Age and experience have helped me tame the animal spirit, but knowledge of how I react to market stimulus will continue to grow.