James Montier Background (via GMO):
Mr. Montier is a member of GMO’s asset allocation team. Prior to joining GMO in 2009, he was co-head of Global Strategy at Société Générale (OTCPK:SCGLY). Mr. Montier is the author of several books including Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance; Value Investing: Tools and Techniques for Intelligent Investment; and The Little Book of Behavioural Investing. Mr. Montier is a visiting fellow at the University of Durham and a fellow of the Royal Society of Arts. He holds a B.A. in Economics from Portsmouth University and an M.Sc. in Economics from Warwick University.
Part 1: Interview with James Montier: Value Investing – Tools & Techniques for Intelligent Investing
Miguel: James it’s a great pleasure to have you here. Thank you for taking the time to answer my questions and tell us about your latest book.
Your book is called Value Investing – Tools & Techniques for Intelligent Investing. Luckily for us it is an annotated collection of your best pieces for Soc Gen. That said I’d like to ask you some questions to better introduce your writing to our readers.
Let’s talk about the concept of seductive details…can you give us an example of how investors are trapped by irrelevant information?
James Montier: The sheer amount of irrelevant information faced by investors is truly staggering. Today we find ourselves captives of the information age, anything you could possibly need to know seems to appear at the touch of keypad. However, rarely, if ever, do we stop and ask ourselves exactly what we need to know in order to make a good decision.
Seductive details are the kind of information that seems important, but really isn’t. Let me give you an example. Today investors are surrounded by analysts who are experts in their fields. I once worked with an IT analyst who could take a PC apart in front of you, and tell you what every little bit did, fascinating stuff to be sure, but did it help make better investment decisions? Clearly not. Did the analyst know anything at all about valuing a company or a stock? I’m afraid not. Yet he was immensely popular because he provided seductive details.
Miguel: Interestingly you connect the dangers of irrelevant information to modern risk management. I’m referring to your comments on Value at Risk – “VAR is fundamentally flawed after all it cuts off the very it of the distribution that we are interested in: the tails! This is akin to buying a car with an airbag that is guaranteed to work unless you have a crash…” Can you tell us more?
James Montier: Sure. Modern risk management is a farce; it is pseudoscience of the worst kind. The idea that the risk of an investment, or indeed, a portfolio of investments can be reduced to a single number is utter madness. In essence, the problem with risk management is that is assumes that volatility equals risk. Nothing could be further from the truth. Volatility creates opportunity. For instance, was the stock market more risky in 2007 or 2009? According to views of risk managers, 2007 was the less risky year, it had low volatility, which they happily fed into their risk models and concluded (falsely) that the world was a safe place to take risk. In contrast, these very same risk managers were saying that the world was exceptionally risky in 2009, and that one should be cutting back on risk. This is, of course, the complete opposite of what one should have been doing. In 2007, the evidence of a housing/credit bubble was plain to see, this suggested risk, valuations were high, it was time to scale back exposure. In 2009, bargains abounded, this was the perfect time to take ‘risk’ on, not to run away. Risk managers are the sorts of fellows that lend out umbrellas on fine days, and ask for them back when it starts to rain.
Miguel: I’d like to transition to another concept, “narrow framing – our habit of not seeing through the way in which information is presented to us”. Give us an example of how this harms investors.
James Montier: The best example of narrow framing that I can think of is the use of pro forma earnings. Think about what pro forma earnings mean….Essentially this is a company turning up and saying, hello I’m lying to you, these are the earnings I didn’t make, but I’d be jolly grateful if we could all just pretend I did. So what do our legions of analysts do, they don’t question the use of these made up numbers, they go and write up the press release, like some overpaid PR machine. Investors regularly fail to look through the way information is presented to them in this fashion.
Miguel: You talk about the benefits of reverse engineering DCF models – as a check on implied growth rates. Run us through the basic steps of a reverse dcf?
James Montier: In theory DCF is a great way of valuing a company (in fact, the only way). However, its implementation is riddled with pitfalls. With enough creativity a DCF can turn out any answer you like. So rather than try and combat this, I prefer to use reverse dcf. This effectively takes the market price, and backs out the growth that would be required to justify the current price. I can then compare that implied growth against a historical distribution of all company growth rates over time and see whether there is any chance of that growth actually being achieved.
In terms of the mechanics, these things can be as simple or as complex as you like. I tend to use a three stage model. I use the analyst inputs for the first three years, a trend GDP related growth rate for the terminal years, and then infer what the market implies for the middle period of growth.
For instance, at the moment the mining sector implies 12% growth p.a. each and every year for the next two decades! That is a cyclical sector with an implied growth rate double a generous estimate of nominal GDP growth. Cyclicals masquerading as growth stocks rarely end well for investors.
Miguel: Tell us about the price = quality heuristic? Why do investors overpay for beauty and underpay for toads…after all they are one step away from becoming princes, are they not? This heuristic complements the Anginer, et all study where ugly defendants are more likely to be found guilty and receive longer sentences than attractive defendants.
James Montier: We humans have a bizarre bias against a bargain. For instance, my friend Dan Airely has done some great experiments in this field showing some pretty odd findings. Imagine you taste two glasses of wine; one you are told comes from a $10 bottle, the other comes from a $90 bottle. You will almost certainly say that the $90 wine tastes much better. The only snag is that the two wines are exactly the same. So never come to dinner at my house, because I’ll give $10 wine, and tell you it costs $90!
The same thing happens with pain killers. It is why branded pain killers exist alongside generic equivalents. They both have exactly the same active ingredient, but people report the branded version works better.
I suspect that something similar happens with stocks. Stocks are the one thing we don’t like to see on sale. So a ‘cheap’ stock must have something wrong with it, and an ‘expensive’ stock must be a sign of quality – at least that’s the way we tend to view things.
The Anginer et al study shows some similar findings in the legal context. Ugly defendants get far worse sentences than attractive defendants. We have a hard time believing that attractive people could have been bad – a kind of halo effect, if you will.
Miguel: This Q/A would not be complete without mentioning the Trinity of Risk. Tell us about the Trinity of Risk. Which of the three components do you think is the hardest to monitor, why?
James Montier: As I mentioned earlier, I don’t think of risk as a number, but rather as a permanent impairment of capital (as Ben Graham put it). Now that permanent impairment can be generated by three potential sources (which aren’t mutually exclusive). First, there is valuation risk – you can simply overpay for an asset. Second, there is fundamental or business risk – something goes wrong with the underlying economics of the asset. Third, financing risk or leverage (which no matter how hard you try can’t make a bad investment good, but can make a good investment bad).
I’m not sure that any of them is easier or trickier to monitor. I think you to consider all three aspects in order to gain a holistic view.
Miguel: Why are we so terrible at predicting our emotions?
James Montier: I wish I knew. However, all the evidence shows that we are truly appalling at predicting how we will act in the heat of the moment. On a ‘up’ day in the market we tend to feel confident and happy, and are sure that we would buy more at a lower price. However, when that lower price arrives, we are caught like rabbits in the headlights. Learning to master your emotions is one of the most valuable things that investors can learn to do.
Miguel: You say knowledge doesn’t equal behavior. What a wise statement; tell us more.
James Montier: Regrettably, knowledge and behaviour are not the same thing. As you know (because we’ve met), I am a large man (on the BMI I am on the boarderline between overweight and obese). Now I know this, and I know that the easiest way for me to remedy this situation is for me to eat less. Sadly, I love food, and thus I don’t cut down my consumption. So despite my knowledge my behaviour doesn’t change. The same is true when it comes to investing. Realizing that we are prone to behavioural biases is an important first step, but it isn’t enough. We need to force ourselves to actually change our behaviour by altering the way we approach investing.
Miguel: James I have to say I’m confident an investor could read your 10 tenets of investing and with diligence outperform major indices. However, I’d like to ask you to elaborate on several of these principles.
1. Tell us how you look at cycles. Are there any indicators or measurements you rely on?
James Montier: Personally I’ve never really found it that tricky to know where we are in a cycle. There are a lot of indicators that gauge exactly that sort of thing from the ISM to the ECRI measures. The Philly Fed have a good (by which I mean timely) index called the ADS measure which tracks where we are in real time.
Miguel: 2. You praise skepticism…How do you balance skepticism with (a perma bear) bias?
James Montier: To me skepticism means questioning what I hear. That tends to lead to a contrarian perspective. When everything I hear is bullish skepticism, that leads me to be bearish, and when everything I hear is bearish, skepticism pushes me to be bullish. If this time ever does prove to be different then I’ll miss the boat, but so far it hasn’t proved to be the case.
Miguel: 3. History matters: Name 3 of your favorite financial history books.
James Montier: Kindleberger’s Manias, Panics and Crashes is just awesome. As is Devil Takes the Hindmost by friend and colleague Edward Chancellor. My third choice would be Engines That Move Markets by another friend, Sandy Nairn. If I were allowed a fourth it would be J.K Galbraith’s, A Short History of Financial Euphoria. Studying these four books would do most investors a much greater service than studying for a CFA.
Miguel: 4. I also find your Paul Wilmot and Emanuel Derman quotes quite interesting.
“I will remember that I didn’t make the world, and it doesn’t satisfy my equations”
“Though I will use models bodly to estimate value, I will not be overly impressed by mathematics”
“I will never sacrifice reality for elegance without explaining why I have done so”
“Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights”
“I understand that my work my have enormous effects on society and the economy, many of them beyond my comprehension”
James Montier: I’ve long argued that those of us who work in finance should take a form of the Hippocratic oath - to do no harm. It never ceases to amaze me the way we constantly embrace the latest fad or innovation, when they are just replicates of things we’ve seen before. Take CDOs, they looked exactly like the CBOs which turned up during the junk bond mania of the late 80s. Anyone familiar with that era couldn’t help but notice the uncanny parallels with more recent events.
Miguel: Let’s talk about the work of Lerner & Phil Tetlock: Tell us about the detrimental effects of holding people accountable for outcomes.
James Montier: My work in this field was sparked by listening to gold medal winners being interviewed at the Olympics a few years back. Invariably the interviewer would ask them what was going through their minds before the race started, where they focused on the gold? The response always came back that they were always focused on what they had to do (i.e the process) not on the outcome (the medal).
Process is the one aspect of investing that we can control. Yet all too often we focus on outcomes rather than process. Yet ironically, the best way of getting good outcomes is to follow a sound process. The research shows that holding people accountable for outcomes tends to lead to suboptimal performance, generally because they spend all their time worrying about the things they can’t control. I’d advise a far better approach to assess people on the criteria of adherence to process.
Miguel: Tell us about your research on Bob Kirby’s Coffe Can Portfolios. What do these findings imply about investment behavior?
James Montier: Bob Kirby was an investment great. His writings on investing are right up there with the best, yet he remains a name that is relatively unknown. One of his papers was on the subject of the coffee can portfolio. He harked back to the days of the old west, when people would keep their most prized possessions in a coffee can under the bed. Kirby argued that investors should behave in a similar fashion, and create a portfolio of stocks that they would be happy to hold in a can and forget about (he called this passively active as opposed to actively passive).
Today we seem further away than ever from Kirby’s ideal. It appears as if investors have a chronic case of attention deficit hyperactivity disorder. The average holding period for a stock on the New York Stock Exchange is just 6 months! This has nothing to do with investment, and everything to do with speculation. Having a longer time horizon than these speculators appears to be one of the most enduring edges an investor can possess. If everyone else is jumping around only concerned with the next two quarters of earning announcements, then they are likely to end up mispricing assets for the long-term.
Miguel: Tell us about your deep value screen borrowed from Ben Graham (page 207)
James Montier: Ben Graham is one of my investing heros, so when I came across a screen he’d designed shortly before his death I was intrigued. I set it up and have been running it for over a decade now. The criteria are simple (as is all good investing). The stock must be cheap (with an earnings yield at least twice the AAA bond yield), it must be returning cash to shareholders (with a dividend yield of at least 2/3 of the AAA bond yield), and it must have limited leverage (with total debt less than 2/3 of tangible book value). I added one extra criterion, a Graham and Dodd PE (current price over a 10 year moving average of earnings) of less than 16x times. I added this is to prevent us from buying cyclicals which had enjoyed a short sharp run up in earnings, but didn’t have sustainable earnings power.
I’ve used the screen for both top down and bottom up work. The bottoms up benefits are obvious; it can provide us with a list of stocks which make sense as a starting point for a portfolio. From a top down perspective I find the number of opportunities showing up tells me something about the overall state of the market. If I can find a plethora of potential investments then the overall market is likely too cheap (or at least a large part of it). A prime example was the largest number of stocks passing the screen I’d ever seen in late 2008, early 2009 – which made me feel very bullish. In contrast, the dearth of opportunities in 2007 suggested the need for caution. Right now I’m not finding massive amounts of opportunity, in fact I'm finding less than half the number of stocks passing this screen now compared with late 2008.
Miguel: Tell us about the folly of using price to sales as a proxy for value.
James Montier: Price to sales is fine if you are looking for short candidates, but as a long side value criteria it makes no sense. After all as long as you promise to value me on price to sales, I’ll set up a business selling $20 bills for $19…I’ll never make a profit, but if you are looking at price to sales you won’t care.
Price to sales is typical of the drift up the income statement when the bottom line gets too demanding. If your PE starts to look expensive, get everyone to look at a less demanding metric, enter stage left price to sales. If that starts to look tough, abandon the income statement and look at the value based on eyeballs and clicks!
Miguel: What I enjoy about your writing is that you aren’t afraid to talk about “controversial topics” – I’m talking about your work on short selling. Can you quickly tell us what you have learned about short sellers (their characteristics, screens, etc.)?
James Montier: Short sellers are everyone’s favorite scapegoats. They make money when things go ‘wrong’. Of course, what the authorities forget is that simply because a short seller sells a stock, doesn’t mean it goes down – if only it were that easy we’d all be short sellers. As David Einhorn observed, I’m not critical because I’m short, I’m short because I‘m critical.
In my experience, short sellers are amongst the most fundamental investors you’ll come across. They understand the ins and outs of a business better than just about everyone else. They are highly skilled at figuring out poor economics when they see if. They are as acting police, helping to uncover fraud – something that the regulators used to do (a very long time ago).
My own work on short selling has focused on a number of areas. In general, shorts tend to come into a couple of categories: bad businesses (i.e. poor economics), bad accounting (obvious), bad management (the guys at the top haven’t got a clue). In addition I often look for several traits, such as expensive, unrealistic growth expectations, too much debt, and poor capital discipline (i.e. needless and tangential M&A).
I also created a measure called the C-score (C is for cheating or cooking the books). It aims to look for the quantitative red flags which often accompany bad accounting.
Excerpt: Details of the C score Page 263 of Value Investing Tools & Techniques for Intelligent Investment:
1. A growing difference between net income and cash flow from operations.
2. Day sales outstanding is increasing.
3. Growing days sales of inventory.
4. Increasing other current assets to revenues.
5. Declines in depreciation relative to gross property plant and equipment.
6. High total asset growth.
Miguel: You uncover some fantastic research linking the characteristics of psychopaths with management styles. It seems like your checklist in this area is essentially a screen for narcissism.
James Montier: Yes, this kind of fits in with the bad management aspect that I mentioned above. There is some intriguing work arguing that many managers share a lot of traits with psychopaths (minus the violent tendencies). The checklist I use is as you say essentially a screen for narcissism. I’m trying to weed out those who are so caught up in their own self importance that they wouldn’t see a problem coming even if bit them on the ass.
Miguel: Thanks again for answering our questions. We wish you and your family the best of health.
James Montier: It has been my pleasure Miguel. Keep well.