After our best relative performance month in September (where I cited that I couldn’t pinpoint the fundamental reasons behind that outperformance), as expected, there was a sharp turnaround as the global equities markets reverted with a vengeance and, at the same time, took away some of that outperformance. I must admit that again, I can’t quite grasp the reasoning behind the market reversal. Although the magnitudes were not as extreme as the US (S&P500 -9.3% in Sep vs +8.0% in Oct), the trend was the same here in Japan (Topix -6.5% in Sep vs +5.1% in Oct). However, in both months, volumes in Japan felt much lower than normal seasonality. In fact, September recorded the lowest Sep volume and October the second lowest Oct volume in the last 20 years. Conversely, the US was above normal seasonality for both months. So, I’d say that we were simply following the US, but with much less conviction.

 

As October was pre-earnings season, there isn’t much to say on an idiosyncratic level except for the reversion factor which was more or less like the market as a whole on a single stock level. As such, we did as we normally do when markets swing like this … nothing. We traded almost zero shares in both months. As I had mentioned in the past several monthlies, we like how we’re positioned and until we see a change in core fundamentals, we will likely continue to trade very little. I fear that the markets may continue to trend optimistically as we enter the holiday season while the Fed tries to thread the needle between taming runaway inflation and sparking a global recession (personally, I think the Fed cares a lot less about causing a slowdown and perhaps might even welcome it to a certain degree, but the markets seem to hope that they can). But we don’t trade sentiment; we follow fundamentals and what we believe is baked into the stock price in terms of forward outlook. And broadly speaking, we still see more risk than opportunity. While valuations look much more attractive, I still believe forward earnings forecasts are still too high, making earnings-based valuations useless. However, we do notice some areas where extreme pessimism may have been fully priced in. We will watch how such stocks trade during this earnings season before we consider taking any action. I doubt we will make any abrupt changes for the remainder of the year but continue to research replacements to eventually return our portfolio to a neutral, less defensive tilt than it is currently positioned.

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Masaki Gotoh

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“All you need in this life is ignorance and confidence; then success is sure.” – Mark Twain, American writer.

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I’m insatiable when it comes to information; I simply can’t get enough. My colleagues are also similar … whenever some topic, any topic, comes up, we immediately grab our phones and Google it. I envy the children of this generation. When I was their age, my only source was the library. Some of my more affluent friends owned the entire Encyclopedia Britannica which I always envied (and, inevitably, it was those who owned it who didn’t share this thirst for knowledge and the encyclopedia would collect dust in their den). But now, you can get everything with a few clicks (and some common sense to sort between fact and fiction). My older son appears to have inherited this passion and spends quite some time each day reading (after I tell him to stop playing games, of course). And I still learn new tidbits from him. He recently told me that baby koalas eat their mother’s fecal matter. I didn’t believe him, so I looked it up and, sure enough, they do! Separately, I recently learned that penguins frequently change partners. And despite what those adorable, family-loving penguins in La Marche de l’empereur described, the emperor penguin switches partners 85% of the time from one year to the next (if you’d like to know more about penguins and other animals, I found this fun fact in a book called “The Truth About Animals” by Lucy Cooke which I randomly clicked on Amazon recently. Be forewarned, though; the content will make you blush more than reading the Fifty Shades series!).

 

There is an infinitely vast wealth of information that I still yearn to absorb. But I have also mentioned in my previous monthlies that, often times, doing nothing is the most productive course of action. What is extremely difficult is to do both, absorb as much information as one can, often conflicting ones when it comes to equity markets, and make an explicit choice to do nothing (and not from indecision). It is very tempting to want to use that information to trade; it might almost seem like a waste not to. I know I used to feel that way when I first started proprietary trading (using a quantitative modelling technique of all things). I learned terms like stop-losses and Sharpe ratios. As I moved more toward fundamentals, I’d use knowledge to churn the book, making our brokers very happy. But over time, I learned to control the urge to trade excessively while continuing to satisfy my hunger for information. Of course, sometimes, one needs to react to new information. Often, we would buy on bad short-term news and trim on good short-term news (not necessarily immediately). But sorting between the irrelevant information vs actionable information is not an easy task. We probably reject information more frequently than acting on it (after acknowledging, understanding, and absorbing it, of course). Doing nothing takes a lot of work and even more will power.

 
And so, I found a rather interesting article by Matt Levine on Bloomberg titled “People Will Pay for Illiquidity” very recently. He says:

 

“If you can buy or sell something whenever you want at a clearly observable market price, that is efficient, sure, but it can also be annoying. Consider the following financial product: 1. You give me the password to your brokerage account, 2. I change it, 3. You can’t look at your brokerage account for one year, because you don’t have the password. 4. At the end of the year, I give you back your password and you pay me $5. Is this a good product? … I would argue, it’s pretty good. For one thing, you avoid the stress of looking at your brokerage account all the time and worrying when it goes down. For another thing, you avoid the popular temptation of bad market timing: You can’t panic and sell stocks after they fall, or get greedy and buy more after they rise, because I have your password.”

 

He then argues how private equity is in the business of selling illiquidity. The original text is so much better than if I paraphrased so let me copy it here:

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“If you are a big institution and you buy stocks in public companies, the stocks might go down, and you will be sad for various reasons. You might be tempted to sell at the wrong time. You will have to report your results to your stakeholders, and if the stocks went down those results will be bad and you will get yelled at or fired. Whereas if you put your money in a private equity fund, it will buy whole public companies and take them private, and then you won’t know what the stock price is and won’t be able to sell. The private equity fund will send you periodic reports about the values of your investments, but those values won’t necessarily move that much with public-market stock prices: The fund will base its valuations on its estimates of long-term cash flows, and those will not change from day to day. By being illiquid, the private equity fund can look less volatile. Getting similar returns with less volatility is good; getting similar returns and feeling like you have less volatility also might be good.”
 
Illiquidity can be good. It keeps you from selling in September 2022 and then buying in October 2022. Ignorance can perform the same task in public equities. For someone like me who is addicted to knowing, ignorance isn’t an option. But the art of ignoring is. In my case, it’s a learned trait that took years of discipline and training. Resisting temptation is strenuous, but that is why the investment philosophy is so important for an equity strategy that take a long view. As Neil McCauley in Heat (played by Robert De Niro) said, “that’s the discipline”.​

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