“Once we realize that imperfect understanding is the human condition, there is no shame in being wrong, only in failing to correct our mistakes.” --George Soros
How much does human behavior affect the markets? Are there significant opportunities or value traps because investors are betrayed by their own thinking processes?
George Soros (Trades, Portfolio) certainly thought so, and made a fortune proving his point. An Investopedia article points out that $1,000 invested in 1969 would be worth more than $4 million in 2017 (assuming you invested and stayed invested—a big assumption).
Soros was able to generate those returns because of his early and enduring interest in a scientific theory called “reflexivity.”
Who is Soros?
The hedge fund billionaire was born in Hungary in 1930 as György Schwartz; his parents changed the family name to Soros in 1936 because of growing anti-Semitic persecution. The family survived the Nazi occupation as well as the early Soviet domination of Hungary, and Soros emigrated to England in 1947. There, he earned bachelor's and master's degrees in economics at the London School of Economics.
After graduating, he found no jobs and had to work as a traveling salesperson, selling to retailers in Welsh resorts. Although he has used his experience in sales to fight Bill Ackman (Trades, Portfolio) over Herbalife (HLF), he did not like the job, later calling it the low point in his life.
Eventually, he got jobs in two British financial firms, one of which led to a job in New York City in 1956. At F.M. Mayer on Wall Street, he worked as an arbitrage trader, focusing on European stocks.
In the late 1960s and early 1970s, he set up the Double Eagle hedge fund while working at Arnhold and S. Bleichroeder. The fund was later called the Quantum Fund; profits from it would be used as seed money when he got together with guru Jim Rogers to start Soros Fund Management. Quantum would be a hedge fund, and Soros Fund Management would be its investment advisor.
The two entities would be highly successful, of course, and Soros would become an investment superstar. That was cemented by famously shorting the United Kingdom’s pound sterling in 1992. He shorted $10 billion, is said to have profited by $1 billion and became known as "The Man Who Broke the Bank of England."
With his great wealth, Soros has become a philanthropist and contributor to liberal social ideas, as well as liberal-leaning politicians (including presidential candidate Hillary Clinton in 2016).
Challenging life experiences confronted young Soros, but he appears to have taken them head-on, learned from them and built on them.
What are the companies?
Soros Fund Management advises the Quantum Group of Funds. Wikipedia says the Quantum Fund became the lead in the fund family, and it was through this fund Soros made his bet on British currency.
According to Niall Ferguson's book, "The Ascent of Money", Soros bet the entire fund on that one short sale. The fund was also involved in the devaluations of Southeast Asian currencies in 1997.
The Quantum Fund made a sharp turn in 2011, when Soros returned outside money to investors and turned the fund into a family investment group; it now manages only the capital of the Soros family—more than most funds will ever handle! Soros said a Dodd-Frank requirement to register with the Securities and Exchange Commission would interfere in his confidential relationship with his clients.
Philosophy and strategies
Soros’ philosophy began to take shape when he studied under the renowned Karl Popper at the London School of Economics. From Popper, he learned about reflexivity.
As an article at Macro Ops explains, reflexivity centers on the existence of two realities. One is objective; this reality is made up of verifiable observations and facts. The second is subjective (or perceived reality); it is what we think about certain phenomena. In the case of financial markets, there is no perfect information, so we can only make educated (or uneducated) guesses.
For example, as pointed out by Macro Ops, Amazon (AMZN) has essentially generated no earnings in relation to its market cap, but buyers keep pouring in because they have formed positive beliefs about the stock. In turn, the growing number of investors and capital committed has had several positive effects on Amazon's fundamentals. These include cheaper financing costs, attracting talent and undercutting competitors' prices to gain market share, since profits are not a priority. These positive effects then help push the share price up.
Soros sees the markets constantly diverging from reality—so prices are consistently wrong. If the divergence is sufficiently large, because of perceived reality, then they will lead to booms and busts. He sees these big divergences as opportunities for traders because that is where the money lies.
Value investors already follow this dictum to one extent or another, as they seek out mispriced stocks that are being driven too far in one direction or another because of misplaced optimism or pessimism.
An Investopedia article describes Soros as a global macro player; in other words, he can invest anywhere and in anything tradeable. He is said to trade in currency rates, commodity prices, stocks, bonds, derivatives and other assets.
More specifically, he is considered a short-term speculator who makes very big, very leveraged bets on the direction of financial markets. While he does research and studies his targets, he is also an opportunist who acts on his intuition.
The Investopedia article uses housing prices to illustrate Soros' thinking about reflexivity:
- Lenders make it easier to get mortgages,
- More people take out mortgages and buy homes.
- Demand increases, leading to rising home prices.
- Higher prices encourage lenders to lend more.
- An upward spiral develops, and prices become artificially inflated.
- The sector collapses.
When this virtuous circle could potentially become a vicious circle, that it is time to short the stocks of home builders and lenders.
Behavioral issues have been gaining a larger place in finance in recent years, as both academics and investors themselves try to identify why they do what they do. Soros was using these ideas for decades, and using them to generate outperforming returns.
Holdings
The following sectoral chart shows a diversified basket of equities:
These are the top 10 equity holdings, as listed by GuruFocus:
- Liberty Broadband Corp. (LBRDK, Financial): 22.13%
- Alibaba Inc. (AABA, Financial): 5.57%
- Caesars Acquisition Co. (CACQ, Financial): 3.67%
- Time Warner Inc. (TWX, Financial): 3.13%
- TiVo Corp. (TIVO, Financial): 3.06%
- EQT Corp. (EQT, Financial): 2.47%
- Mondelez International Inc. (MDLZ, Financial): 2.13%
- The Kraft Heinz Co. (KHC, Financial): 1.59%
- Viavi Solutions Inc. (VIAV, Financial): 1.45%
- Edgewell Personal Care Co. (EPC, Financial): 1.45%
At the TipRanks website, Soros is listed as having $4.2 billion in assets and, as seen above, he has just over $3.3 billion in equities, leaving some $900 million available for trading in currencies and other activities.
Now that Soros deals only with “family office” assets, has he become more conservative? That seems likely, given the five-year returns shown below.
Performance
Soros has had many amazing years, along with a few dogs. In many years before the financial crisis, he had a Midas touch.
In the last five years, though, he has only kept up with the hedge fund average, and that is well below the gains the S&P 500 posted over the past five years. This chart from TipRanks compares his results (blue) with the hedge fund average (orange) and the S&P 500 (purple):
Have Soros’ returns gone down because he is now a family office investor, or because he has slumped like so many other hedge fund managers in the past nine years? It is a question without answers for outsiders.
Conclusion
Whatever the answer to performance questions, one thing is certain: Soros made himself and many of his clients wealthy by using insights into human behavior, insights that came from studying reflexivity.
Reflexivity can help organize one’s thoughts about behavioral finance in such a way they become an integrated and coherent whole. From there, the next step is to use that knowledge to make better and faster decisions.
For value investors, studying Soros and reflexivity could lead to better investments; as for making big bets on obscure trends, that is best left to daredevils.
Disclosure: I do not own shares in any of the companies listed, and I do not expect to buy any in the next 72 hours.
