Noise - Chapter 8
Sources Of Noise: Releases
Briefly: Releases
Noise. Releases of macroeconomic data and company results can interfere with your ability to make sensible investment decisions.
Paradox. The more important the macro release, the less time you should spend trying to predict it.
Heresy. If you compete on the basis of your ability to better predict companies’ earnings, you’re unlikely to win the active equity game.
There is a vast amount of macro and micro data that is released every trading day, and the schedule for these announcements stretches out into infinity. The sheer quantity of it all makes it a problem to deal with. That’s one reason that releases are a source of noise.
Some releases are important, others are not; some of the new data will move prices, some of it won’t. And for a lot of the time, you won’t know which will and which won’t. That’s another reason that releases are a source of noise.
It’s a mistake to equate noise with irrelevance, something that can be easily dismissed with a wave of your hand. Releases give you an update on what is happening in the financial world, and so it would be a bad idea to simply try to ignore them because they are noisy. But it would also be a mistake to allow yourself to be overwhelmed by trying to ingest the entirety of this unstoppable tide.
This means that, at the most superficial level, a way to deal with this source of noise is to decide which releases are important to you. So far, so obvious. When you make this decision it should naturally be a function of what is required for your investment process, which, in turn, should be built around whatever you consider to be your competitive advantage. This also seems obvious, but it is put into action by surprisingly few fund-management firms.
Macro
There was a myth amongst the early sailors that beyond the mapped parts of the oceans lay great terror, either the edge of the world or ship-destroying monsters. Modern fund managers labour under an inversion of this myth: that beyond the choppiness and anxiety surrounding this week’s releases lies calm water that will be easy to navigate. This sort of guff gets said in the media and repeated in way too many morning meetings. A part of you knows this to be utter nonsense, because there is a perpetual conveyor belt of releases and announcements that’s never going to stop and you will never receive the all-clear signal. Another part of you, hopefully a small part, that buys the myth opts you into a perpetual state of hyperventilation and distraction. That’s not good.
Yeah, you may say, but what about really important numbers, like the US federal funds rate? You may have an edge in making better predictions than your competitors about the next move by the Federal Reserve, and if you do, you should build that edge into your process. But, perhaps unkindly, I doubt that you have such an edge, which means that you probably allocate too much of your scarce resources to this one piece of data. This is probably the most watched and analysed release in the financial world because it is so important, and that very fact makes it an extremely unlikely place to find alpha. If you don’t have a first-order advantage in predicting the Fed’s moves, perhaps you have an advantage in capturing the second-order consequences of the FOMC decisions, perhaps the ability to construct a clever position to exploit possible shocks. Good for you if you do; you should build that into your process, but only if there is a decent chance that you have some edge.
This is the point: the Fed funds rate is a very important macro variable but, other than knowing where it is now and what the consensus forecast is (which you can do with about three keystrokes and which will take you less than 10 seconds), you should apply your mind elsewhere. If you spend any more time on it, then it is a source of noise because it is interfering with the difficult business of finding opportunities where you might actually have an edge. This one release is incredibly important, but you should give it very little of your time. This is a paradox.
That’s just one of the many releases that you might keep an eye on, but the principle applies to all of the others. If you believe that you have better than average insight into the reasons that the market is wrong, then you are expressing a view on where your edge lies. You should certainly apply your resources to taking advantage of areas where you have some informational or analytical advantage, where you have a reasonable prospect of identifying something that others have not. So, be very focussed on exploiting your edge, and rely on consensus for the rest; that’s how you will win in this game. If you get that the wrong way around, you’ll be striving for mediocrity.
Earnings
The variable that is at the core of the investment process of the majority of active equity managers is company earnings. This is practically written on the stone tablet that the sainted Benjamin Graham first brought down from the mountain in 1934. It is an act of heresy to even question the validity of accounting earnings as the basis for evaluating a business. But the periodic announcements by companies of their earnings are noisy affairs that can get you into trouble, especially if your process is built around making accurate predictions of earnings, because the behaviour of company managements ranges from game-playing to outright deceit.
Guidance Games
The managers of listed companies have long understood that the market responds positively to an earnings beat. In a game that seems ultimately futile but which is assiduously played nonetheless, company managements use their interactions with analysts to guide down market expectations so that they can produce a positive surprise. In the ten years after the Global Financial Crisis, announced earnings have beaten near-term consensus expectations 70% of the time. You might want to build this into the way that you deal with consensus forecasts.
Accounting Games
Generally Accepted Accounting Principles (GAAP) are designed to improve the reliability and validity of financial statements so that you can have a reasonable chance of making an accurate assessment of a company’s value. But GAAP is not entirely successful in this regard.
At the one end of the spectrum, GAAP forces company managements to account for certain items in a way that obscures the underlying economic reality of the business. An example is where a company is treated punitively, from an accounting perspective, for investing heavily in the innovation that should drive future growth. The R&D investment in intangibles such as brands must be expensed immediately in the same way that one would treat items such as salaries and rental, which unfairly burdens the income statement of innovating companies. Complicating the picture, and making accounting earnings inconsistent, is that this is only true of internally generated intangibles; if intangibles like patents are acquired, they can be capitalised rather than expensed.
At the other end of the spectrum, GAAP is so lax in certain areas that it allows company managements to intentionally obscure the health of the business, without resorting to anything that is illegal. Managements are given a lot of leeway in their marking to market of certain assets, and for the writing-off of impaired assets and goodwill. At its most benign, this gives rise to a host of once-off items in the income statement, which increases the noisiness of the earnings numbers.
These two management games, guidance and accounting, might be the reasons that the investment gains from predicting corporate earnings beats and misses have been declining for thirty years to the point where the returns from perfect earnings prediction are no better than would be produced by a simple momentum strategy. If your predictions of company earnings are less than perfect, you might need to look elsewhere for your competitive advantage.
Management Deceit
The guidance and accounting games of company managements are child’s play when compared to outright deceit and fraud.
Example: Viceroy Research Group
Viceroy describes itself as an investigative financial research group. It periodically publishes reports on companies where it believes that company managements have materially misrepresented the facts to investors. These reports are sometimes accompanied by short positions in the stocks by Viceroy or its associates.
Viceroy became more widely known in the investment community when it published a research report in 2017 on Steinhoff, a furniture retailer listed on the Frankfurt and Johannesburg stock exchanges. Viceroy’s interest was piqued because Steinhoff had embarked on a decade-long acquisition spree, where it bought up furniture businesses with questionable fundamentals whose post-acquisition performance suddenly appeared to improve.
The market seemed to like what Steinhoff was doing and reporting, which was reflected in the share price that rose almost four-fold in the three years to its peak in April 2016. But some investors were unnerved when a German magazine published a report in mid-2017 that Steinhoff and members of its management team were under investigation for fraud. The company rejected allegations of dishonesty, saying that the magazine had its facts wrong.
Then Viceroy said in its report in December 2017: “Steinhoff’s financials show significant difficulty in converting its earnings into cash flow. The source of this discrepancy appears to be a combination of off-balance sheet vehicles inflating earnings and accounting shenanigans.” The depth of analysis in the report was damning enough to precipitate the resignation of Steinhoff’s CEO, as well as a 98% collapse in the company’s share price over the next six months.
When material announcements have not been anticipated and priced, they can give rise to acute volatility. You can exploit the noisiness of the announcements and the noise experienced by your competitors if you have identified your informational, analytical, or behavioural edge. If, however, you spend time with your team in a morning meeting to merely rehash the previous day’s company results, perhaps expressing surprise but without a clear idea of how you might execute around your edge (if it exists), you are misallocating your scarce resources and you are a victim of noise.
Events
When you became a fund manager you moved into a tough neighbourhood where people don’t always fight fair. If you think your competitors are out to get you, it doesn’t necessarily mean that you’re paranoid. Sometimes they are. Sometimes announcements around corporate events are not what they seem.
Example: GSO Capital Partners
GSO is a hedge fund unit within the world’s largest private equity firm, Blackstone Group. Under the leadership of Akshay Shah, GSO’s $3 billion distressed debt fund became infamous for its investment strategies in the European credit markets. Shah attracted significant disapproval from his competitors for actions that they considered to be borderline legal.
One of GSO’s most profitable strategies was the so-called manufactured default, an example being GSO’s involvement with a troubled Spanish gaming company, Codere. GSO bought credit default swaps in the company from competitor hedge funds, and then offered Codere a much-needed injection of liquidity on condition that the company delay for a few days the payment of the coupon on its public bonds. This small time delay was of no particular concern for the bond holders who duly received the interest they were owed, but the delay triggered a key default clause, which was a very profitable event for GSO, but not so much for the hedge funds on the other side of their CDS trade.
Another example was GSO’s involvement with a Norwegian paper company, Norske Skog, that was about to go under. GSO sold CDSs to competitor hedge funds who would gain from their CDS positions if the company collapsed. In parallel with the CDS sale, GSO used Blackstone’s balance sheet to buy a substantial equity stake in Norske Skog, which enabled the company to avoid bankruptcy. It also enabled GSO to make changes to the company’s board and convince management to restructure the company in a way that wiped out the value of their competitors’ CDS positions.
The players who were on the other side of the GSO trades were not naive newcomers to the sharp-elbowed world of distressed debt; they included Michael Platt’s BlueCrest Capital Management, as well as the Wall Street bank with the sharpest of elbows, Goldman Sachs. A senior trader at Goldman even took the highly unusual step for someone from that bank to complain in public about the way in which GSO was manufacturing credit events, which he said were contrary to the spirit of the CDS market.
Sometimes releases can seem innocuous, such as the announcement of a few days’ delay in the payment of interest on a corporate bond. But it might be the work of one of your competitors who operates right on the very border of what is legal and acceptable so that he can get an edge. Sometimes it’s not just the fresh-faced kid who gets skinned by the hardened pros.
It’s very difficult to develop an edge in any area, especially one that involves better prediction of something that gets a lot of attention from a lot of your competitors. If you allocate scarce resources to areas where there is a low probability of capturing alpha, you will not produce above-average investment results over time.
This means that you need to be brutally honest with yourself, or hire somebody to be brutally honest with you, so that you can figure out if you have any edge in any area. If you do, or at least have some reasonable chance of having an edge, then you should design your investment process around that edge, and you should be highly disciplined about sticking to your process.
So many fund managers talk this talk, but rather fewer walk the walk. It is those same few who produce above-average investment results over time, and who attract a disproportionate share of the assets that are allocated to active managers. This is not a coincidence.
References
Graham, B. & Dodd, D.L. (1934) Security analysis: principles and technique. New York: Whittlesea House.
Article in The Economist of 1 December 2016: ‘Discounting the bull: sell-side analysis is wrong but in reassuringly predictable ways’, based on a survey conducted by Lawrence Brown of Temple University.
Feng Gu & Lev, B. (2017) ‘Time to change your investment model’, Financial Analysts Journal, Volume 73, Number 4.
Article by Viceroy Research Group retrieved on 15 December 2017 from www.viceroyresearch.org.: Viceroy unearths Steinhoff’s skeletons - off-balance sheet related party entities inflating earnings, obscuring losses.
Article in the Financial Times on 4 June 2018 by Miles Johnson and Robert Smith: ‘The mystery trader who roiled Wall Street.’