Jim Hsu is a neuroscientist, contrarian, centrist and optimist. He specializes in Long, global, distressed investing.
How and why did you get started investing? What is your background?
Like a lot of investors I've read up on recently (see below), I came to the investing table through, well, a non-traditional route. In 1998, I was in 4th grade -- no, really -- and I got a small sum of money, some allowance, but mostly what my parents provided at that time. If you looked at any TV back then, you'd remember the advertising - ads for Etrade and Scottrade, crazy tech companies that got valuations in the billions for simply existing. I started buying Dell (DELL, Financial)Ă‚ and Lucent because that's what I saw on TV and "those guys on CNBC are smart, so they must be right"; they bought Lucent, Oracle and EMC (EMC, Financial); Worldcom and Enron at some point, also.
In 5th grade, our class actually had a paper investing seminar -- "sign of the times", and definitely a bubble in hindsight. I bought Dell, of course (since I actually did have it, and it was making a bundle, percentage wise). Dell was still running commercials nonstop on TV back in those days - again, note the conspicuous presence of media. Some other guys chose Microsoft (MSFT, Financial), Cisco (CSCO, Financial), whatnot, and did alright; I don't remember the rest. We were asked to graph the value of stock every week by checking the Wall Street Journal. Had to tape two additional sheets of graphing paper to the top just to get it to fit. When fifth grade ended, I think I was first or second in the contest (along with some other guy who also bought Dell). This was basically at the height of the tech bubble at this point.
My parents met "Oracle uncle" (who worked at Oracle, and was utterly convinced that Oracle would simply double every 6 months). Did they know what Oracle did? Nah. Easy money. At that time, I think I first read about Alan Greenspan and "irrational exuberance" at this point. ("He's an old guy, doesn't know any better, this time it's different."). Fast forward 6 months -- dotcoms crashed, most portfolios suffered 70%, 80%, or worse drawdowns. Dell didn't do too hot, but it wasn't a Worldcom or an Enron. Still, going through an 80% drawdown with real money in middle school was one of the most important life lessons that I could've had at such an age.
They say that there's nothing new under the sun, and I've tried most of it - growth investing, daytrading, swing trading, small-caps, futures and commodities, option spreads, forex - but what I come back to is some form of value investing. As far as background, my day job is a medical student/resident in training; my major is in chemical biology; my research interests are in bioinformatics and neuroscience. So yes, I really have nothing to do with the financial world besides my passion for understanding the world of investing.
Describe your investing strategy and portfolio organization. What valuation methods do you use? Where do you get your investing ideas from? What drew you to that specific strategy?
I define "value investing" quite more broadly than most. "Value" to me is simply buying the cheap, loathed and underperforming, and selling the expensive, loved, and outperforming. How one defines cheapness or likability is what creates all the arguments.
Among the many who have inspired me to think along this route include Meb Faber of Cambria Investments, the awesome team including Rob Arnott and Jason Hsu at Research Affiliates, Wes Grey's team at Alpha Architect, Ben Hunt with the Epsilon Theory folks at Salient Partners, the many fellows that I've met through Fintwit, which despite its avaricious excesses, manages to produce actionable ideas, and countless others that I haven't included here.
Often, what works -- what is most likely to produce actionable results in investing -- is by taking the most obvious supposition, inverting it, and seeing where that takes you. I'm reminded of a comment made by Dr. Michael Burry of Scion Capital, who said this previously on GuruFocus:
"Tweedy Browne (Trades, Portfolio) has done some proprietary research on this which is mentioned here and there in various investing texts. Their feeling is that the net nets that actually did well when purchased as part of a broad diversified portfolio of them were the ones that had horribly negative earnings rather than positive earnings, and that had business models that didn’t seem viable. This makes sense, because net net is really a proxy for a form of liquidating value, and becomes least relevant in an operating company that is expected to continue to run forever."
Arnott's team at Research Affiliates has done similar research; in one of their latest publications, Ă‚ they show that performance chasing -- investing in the factors (value, momentum, profitability, etc) that has performed the best over a 3-year price horizon -- performs worse than not practicing factor investing ("smart beta") at all. Consequently, investing in factors that perform the worst over a 3-year price horizon actually performs better than an equally-weighed factor portfolio going forward, even accounting for the slightly increased volatility. Other studies have shown that this cost of performance chasing extends to market divestments (Teoh et al 1999; Lytle et al 1997 ), fund managers (Carhart et al 1997, Cornell et al 2016), pension and endowment funds (look no further than the recent brouhaha at Harvard's endowment this year penned by The Crimson), and, of course, individual investors.
Going back to methodology -- I would be lying if I said I had a "systematic approach", but two things stick out to me when attempting to evaluate junk (i.e. potential value investments) -- liquidity and the balance sheet. Basically, is the company a) likely to and b) incentivized to survive the current economic cycle without c) being too dilutive? As for how cheap the company is, pick your poison; research by Alpha Architect shows that EV/EBITDA might be somewhat superior, but arguments could be made for book value, price to sales, smoothed price to earnings (i.e. Schiller CAPE), discounted cash flow, ROIC, etc.
As far the numbers ... I do look at technicals, and it's my humble opinion that any practitioner who regards technicals as astrological gobblygook is missing a crucial piece of the puzzle -- sentiment. Trends matter. Support and resistance matter. The smoothing interval that you use for your Aroon oscillator; well, that might not matter so much. The same applies for fundamental analysis, BTW. I don't care if you use a 15- or 20-yr span to discount cash flows; I do care if your base assumptions are a) realistic, and b) provide a large enough margin of error, or "margin of safety", as some others call it.
What books or other investors changed the way you think, inspired you, or mentored you? What is the most important lesson learned from them? What investors do you follow today?
As a Millennial, we're often accused of "not reading enough", which is roughly translated into not reading enough books. That is correct. What's also correct is the explosion and proliferation of other forms of intelligent, thoughtful media - long-form blog posts, podcasts, recorded panels, etc -- as well as a lot of junk along with it. But to get back to the question, the first "investing" book I read was actually "A Random Walk Down Wall Street" by Burton Malkiel, which I suppose is as good of a first book as any, as being lectured by a Princeton professor about why you're wrong about everything is a first step towards humility. Everyone has an opinion, but mines is that the markets are "efficient seeking" - market dislocations are caused by limits to arbitrage and behavioral biases, as Wes Gray explains repeatedly; most are quickly identified by skilled participants, but systemic risks sometimes cause these dislocations to instead grow, creating liquidity crises.
Other classics I've read include "Securities Analysis" (at least part of it), "Reminiscences of a Stock Operator," "Irrational Exuberance," and" Freakonomics" (which I regard as an investing book like any other). One that many readers might not be as familiar with is "Why Stock Markets Crash" Ă‚ by Didier Sornette at ETH, which is an interesting exploration of how a physicist sees markets. Above all, I believe in following intelligent, thoughtful blogs - Ben Hunt's explorations of market psychology at Salient Partners, Research Affiliates's extensive data mining, Alpha Architect's blog, even Victor Niedenhoffer's Daily Speculations. I don't necessarily agree with everything that comes through the door, which is what makes it all the more worthwhile; it is absolutely essential to be exposed to different perspectives.
Do you use any stock screeners? What are some efficient methods to find undervalued businesses apart from screeners?
"Invert, always invert". Often, many of the companies I'm interested in are edge cases that others exclude via formulaic rules in screeners. Specifically, companies that are sound liquidity-wise, but have massively negative earnings due to systematic risk - oil and coal recently being good examples. This produces companies with ridiculously high or negative PEs, negative ROICs and such that many simply dump from their screeners. When earnings recover, they suddenly look "cheap", and thus other value investors join in, along with the momentum investors that see the impressive annual performance. (After all, flows matter.) Another interesting category are the rare breed of negative enterprise value (NEV) companies, companies with cash in excess of their total market capitalization plus debt. These are some truly awful companies on paper, but a few manage to recover by multiples, leading to impressively high risk-adjusted returns. Again, negative EVs "don't make sense", and so are dumped from many screens by default.
Before making an investment, what kind of research do you do and where do you go for the information? Do you talk to management?
If there's one thing I've learned, it's to stay as far away from management as possible. Management is fine for supporting the consensus narrative; if you need a variant perspective (which you should, if you're to have any opinion on the instrument at all -- otherwise, just "S&P 500 and done"), they should be one of the last places to look at. I believe in trying to dig through unstructured data -- interviews with store managers, former employees (who may have agendas of their own, but still), litigation, consumer surveys, etc. Note that press releases were not included in that list. It's in the unknowable unknowables that provides the opportunities for variant opinions to diverge, which is the source of "alpha" (provided it still exists).
How do you feel about the market today? Do you see it as overvalued? What concerns you the most?
Several comments have been made about today's market with 1999 or 2000 in terms of valuation. What most people generally don't remember are the markets that performed horrifically during the same period - deep value strategies, emerging markets (following the 1998 Asian financial crisis), most forms of active management, energy, basic materials. Not everything crashed during the "dotcom crash"; as I'd learned only a decade later, deep value was up double digits, and many international managers didn't do too badly. In 2015, I saw the same things happening. After more than an 80% drawdown, precious metal miners suddenly looked interesting. Brazil was mired in the worst recession in a century, and Russia, since 1998. Fast forward an year - those two emerging markets are up high double digits, metal miners are up triple digits. Amazingly, they still look "cheap", at least compared to the valuations were seeing in U.S./DM equities and bonds. You do have a choice besides large cap U.S., at least if you're managing your own money. One final area that I'm exploring from more of a macro-based standpoint is Chinese consumer staples; I see a confluence of a number of titanic forces at work here: trade-war fueled currency devaluation; a massive divergence between U.S. staples, which have had one of the best 5-year annualized performances on record, versus the negative performance in China with a widening valuation gap; the growing Chinese middle class; and the socio-political shifts undergoing in a state-run economy looking to transition into a more open market.
What are some books that you are reading now? What is the most important lesson learned from your favorite one?
In general. I don't read the "latest investing book"; those insights come through the many long-form blog authors I follow, in addition to interesting conversation. I do love sci-fi, and so am attempting to get through Iain Banks's "Culture" series as well as some of Neal Stephenson's more recent novels - "Reamde," "Seveneves," "Quicksilver." Things like race and politics take on a different light when you're contemplating the fate of a primitivist society 20,000 years in the future, or a star-faring galactic civilization that uses black holes for entertainment.
How do you manage the mental aspect of investing when it comes to the ups, downs, crashes, corrections and fluctuations?
Most investors check their portfolios far too often, and due to prospect theory, this overall has a hugely negative effect on perceived sentiment. A quick digression: prospect theory is the cognitive theory borne by behavioral research that losses are experienced with significantly greater pain than equivalent gains; thus, when faced with the opportunity to have a low probability large gain with the risk of small losses, investors overestimate the probability of the gain (risk seeking). Similarily, when faced with a high probability of a small gain with the risk of a large loss, investors underestimate the probability of the gain (risk averse). Both of these preferences are satisfied by buying positively skewed strategies (lottery-type payoffs) and “selling” negatively skewed strategies (which includes value investing).
In fact Wes Gray has done some interesting research supporting the theory that replication of private equity involves, in large part, return smoothing, due to the intrinsic illiquidity of PE. This, aside from smoothing large intra-year drawdowns (such as the August 2015 correction), substantially reduces the cognitive load associated with monitoring such a volatile investment, and therefore reduces behavioral errors. So what am I basically saying? Check your portfolio less often.
Any advice to a new value investor? What should they know and what habits should they develop before they start?
Read. Seek out views contrary to your own, and understand them. Be humble.
This applies to many things in life as well, not just investing.
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