Monday, February 21, 2011


Welcome to my new blog. For those not familiar with me, I've been a money manager for the last 25 years, including ten as a mutual-fund manager. I have experience across asset classes, including equities, fixed income, currencies, commodities, precious metals, and REITs.

I believe that investing is as much art, or behavioral study, as it is science. Investing is essentially the combination of valuation and contrarian psychology. Investing in asset classes that are historically undervalued offers a margin for error (or “margin of safety,” as Seth Klarman so eloquently explained in his book of the same title). This is related to contrarian psychology. Asset classes that are undervalued are so because they have become depressed in price. These assets are unpopular among investors, who have a strong herding instinct toward areas that have done well already and whose attributes have become obvious to even casual observers. It follows that an asset’s starting price greatly affects one’s likely return.

A contrarian value approach is easy to aspire to, since it makes so much sense. Buy assets that are selling for less than their true worth, and sell when they are selling for more than their true worth. (Ascertaining their true worth is a question for another day.) That is why many market participants claim to be contrarians, but a far smaller number have the necessary disposition to actually behave like one. Being a contrarian requires defying the conventional wisdom, especially of the supposed experts. Experts--especially economists and market strategists—tend merely to extrapolate recent trends into the future. If they make a bold stand or forecast that is markedly different from their peers, they take a big personal risk. The cost to them of being wrong in such a case is often the loss of employment. So it is much safer for their careers to be in the mainstream, even if it means going over the cliff with almost everyone else, as happened in 2000-2002 and 2008. This is nothing new. As the esteemed British economist (and market speculator) John Maynard Keynes wrote decades ago, "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally." So be skeptical of forecasts, especially when they include the implied precision of decimal points!

Another aspect of a contrarian approach is the notion of risk. Conventional finance theory and institutional-investor practice define risk as an investment's volatility (and unpredictability). In response, Wall Street firms have devised exceedingly elaborate quantitative techniques to measure and purportedly control risk. Such models, devised by mathematical geniuses, appeal to clients who want the latest (and supposedly most sophisticated) approach. In 2008, we learned the limits of these arcane risk-modeling approaches, as they failed to anticipate market breaks, largely because of the assumption that the future would be similar to the relatively recent past. That also is why the record of forecasting is so abysmal, and why Nassim Taleb became a celebrity in pointing out the limits of conventional, linear thinking that fails to anticipate "bolts from the sky (my term)". Those supposedly sophisticated approaches to protecting capital largely failed in 2008 for the second time in less than a decade, as they did in the crash of 1987 when using the technique of "portfolio insurance."

Instead of adopting the conventional view of risk, I view risk simply as the probability of a permanent loss of capital. Buying undervalued assets reduces one’s chances of incurring such a permanent loss, as opposed to buying into a good “story” (at a high price) and hoping to sell at a higher price to another (the Greater Fool Theory). Yes, when asset prices swing sharply it is worrisome, but volatility often presents opportunities, specifically when markets are not in established, long-term trends. Furthermore, the conventional wisdom and conventional finance theory hold that high risk (volatility) leads to high returns, because investors demand a higher return to accept more volatile, uncertain returns. It sounds good in theory. But the wise strategist and behavioral-finance proponent James Montier cited evidence that in the stock market, low risk (volatility or beta) stocks with high dividend yields actually produced higher returns than high risk (beta) stocks. So much for conventional finance theory!

So with this blog, you will not get conventional thinking about investing. Instead, I hope you will get a fresh perspective--and I hope--profitable investment ideas. Stay tuned!

Steve Lehman

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