The Secret Sauce: A Knowledge Advantage

Howard Marks of Oaktree recently offered some excellent thoughts on his investment philosophy and style.  But this one paragraph really jumped out at me:

“What is your secret sauce?

No. 1, it’s possible, especially in inefficient markets, to gain a knowledge advantage. By definition, an inefficient market is one where hard work and skill can pay off. We can also control our psyche and emotions so that we don’t make the human mistakes that are so common. Of course the other thing is we have a philosophy of controlling risk. So that doesn’t necessarily make us the winner rather than the loser in the transaction, but it increases the probability that we engage in transactions of the sort that we and our clients want.”

There are a few ways to access better knowledge in an inefficient market.  You either have better sources, illegal information or you just simply have a superior understanding.  That’s why I always emphasize the importance of a sound top-down approach.  If you don’t understand the monetary system you’re more inclined to make mistakes in micro managing your portfolio.  You make silly mistakes like misunderstanding how the Fed operates, how QE works, how fiscal policy impacts the economy, how bond auctions works, etc etc. Misunderstanding these important macro functions has resulted in endless predictions for hyperinflation, rising bond yields, falling stock prices, etc.  But if you had a sound understanding of the system – if you had a better understanding – you sidestepped all of these predictions that were clearly wrong if you understood how the system works.

You don’t need to cheat or steal to get better information or knowledge.  Sometimes it’s a matter of putting in the effort to obtain it.

*  See my paper on the monetary system here.  

 

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. I still predict higher interest rates. MR is a nice (for the US) servicing theory, so I won’t buy it.

    One should also study the impact of demographics on an economy. When a population is shrinking then an economy is bound to contract as well. And the demographic developments in the US (even without the curremt financial crisis) point to MORE deflation. The US is Japan with a 20 lag.

    Howard Marks also made another remark: Mistakes are made because a person (e.g. one Cullen Roche) THINKS he/she understands what’s going on.

  2. Howard Marks: “It’s not what you don’t know that’ll get you into trouble; it’s what you know for certain that just ain’t true.”.

    Like “The FED determines interest rates”. Right ?

  3. I agree with BV – I dont want to be like Cullen. I dont want to take the time, effort and intellectual doubt that comes with trying to understand a system. I hate reading stuff that tells me I might be wrong. Yuk! I much rather read the stuff that justifies my current beliefs.

    I dont want to give up my time to teach others about how the system works. I much rather come here and write narky little comments.

    I would much rather just get me one of those really simple “off the shelf” ideologies….you know the one that people like you espouse….

  4. CR: “Misunderstanding these important macro functions has resulted in endless predictions for hyperinflation, rising bond yields, falling stock prices, etc.”

    About stocks: Do you mean the Kalecki equation? That’s a good one.

    As another matter: MSCI World peaked in April 2011 and has been mostly down since then until the recent ECB / Fed stimulus.

  5. “If you don’t understand the monetary system you’re more inclined to make mistakes in micro managing your portfolio.”

    i think it´s a bit overrated. to date i have yet to see a star money manager openly discuss MR. for the most it doesn´t matter.

    the popular widowmaker trade so far has been short treasuries. but to avoid such thing you don´t have to be an expert on den monetary system. you simply take a long term chart and look at the trend. same for inflation. once the long term trend reverses you go with it and keep your risk low.

    the main mistake imo is to try to base your trade on your own macro forecast, trying to time a market instead of trading reactionary to actual data.

    and in case of the stock market it´s most important to know, how the market works – the game of expectations and delivery, and sentiment overall. and i agree with Marks – risk control is no1. your edge (knowledge advantage) comes with hard work. you do more than your competitors. for some it means extensive technical analysis. for others (like me) it means working through sec filings and conference calls.

    whatever you invest in – make sure you know your stuff.

  6. “It’s not what you don’t know that hurts you, it’s what you do know that ain’t so.”

    — Generally attributed to Will Rogers, circa 1920’s.

    Also said: “Everybody is ignorant, only on different subjects.”

  7. “Star money managers” usually base their work off of neoclassical beliefs. Like when Bill Gross predicted rising yields after QE2 ended. Does that justify neoclassical economics?

  8. “Like “The FED determines interest rates”. Right ?”

    Right!, most of the time.

    If you don’t believe it, don’t both researching things like the Fed’s daily Securities Lending OMO.

  9. “Don’t gamble! Take all your savings and buy some good stock and hold it ‘till it goes up, then sell it. If it don’t go up, don’t buy it.”
    — Will Rogers

    “If stupidity got us into this mess, then why can’t it get us out?”
    — Will Rogers

  10. Since when is America’s population shrinking? Seriously, where do you get this stuff? Do you honestly believe anything you say here or are you paid to write this stuff by some sadist?

  11. thats exactly what i mean – predictions.

    i don´t consider Bill Gross a star manager. impressive performance, but he profited from the 30year bull market in bonds. his greatest call was during the height of the crisis to “buy what uncle sam will buy”. the coming years will show his true skills. i wouldn´t want to be in his place. the bond market is a wicked thing. and nowhere else you have to deal with that much fed interference.

    when i wrote this line i thought of the Einhorns, Ackmans, Hendrys, Chanos and other lesser known names.

    my point was not to criticize MR or neoclassical beliefs. it doesn´t kill you to believe in the one or the other as long as you keep an open mind and don´t trade based on predictions while ignoring reality.

  12. addendum: one better known example for what i mean is Barry Ritholtz. i never saw him blogging about monetary theories at all. so it seems to him it doesn´t matter at all. still he is great at navigating the markets. and he´s no stockpicker either. his edge is his flexibility and judging of overall sentiment.

  13. Okay, so when David Einhorn says the USA is going to have a debt crisis due to bond vigilantes he’s also proving that he doesn’t understand the monetary system. Most “star money managers” are niche managers. For instance, Einhorn isn’t a great macro thinker. He’s a good micro analyst of companies. Same with Chanos and Ackman. But they don’t understand the big picture. Their edge is in having a better understanding of the micro. That’s fine. I am not against that. But it doesn’t mean that a superior understanding of the macro is not a huge edge.

    I’ve never had a negative year in my history of investing. And I managed my small partnership to gains that crushed the S&P 500. Granted, I never managed money the size of the Einhorns of the world (nor did I ever want to), but most people don’t. Most people are probably closer to my small partnership and my work is living proof that a superior understanding of the macro can generate outsized returns. Granted, I am not “star money manager”, but then again, most of these guys we put on a pedestal as “star money managers” are either frauds or deeply misunderstood due to their niche expertise.

  14. “Most “star money managers” are niche managers… Their edge is in having a better understanding of the micro.”

    i absolutely agree.
    but it doesn´t make their performance any less valuable. and that´s what the average investor can learn from them – find your own way.

    over the last 17years i found that predicting the macro AND the reaction of the markets to it is hardest thing to do. still every day numerous pundits are telling us on tv where the economy and the stock/bond markets are headed.

    your superior understanding of the macro and the monetary system is your edge, that prevents you from Kyle Bass tyle JGB shorts. so you´re one of the rare succesful exceptions. still i think that macro skills are hard to get for the average investor who is reading this fine blog.

    to them risk management should be priority no.1.
    i know you´re a man on a (MR) mission ;)
    but it would be great if you would extend blogging on this issue (risk managemnt and discipline)

    as for Barry – i´m not a 100% sure either where he stands. but it was a guest article in his think tank section when i first got deeper into monetary theory. it was years ago, i can´t find the link or remeber the author. the author basically described how japans monetary system works and why it won´t implode. to me it was a totally new concept and i was immediately reminded of this article when you started focussing on the issue.

  15. Sadist ? No, reality. Americans are known for their optimism. “Real estate will always go up”, remember ?Simple: Demographic trends are more powerful than any government would like to admit.

    More and more women are at the age of 45 and higher. And those women are NOT able anymore to give birth to children. That’s why the US population is bound to shrink.

    Since about 1960 the growth rate of the US population has shrunk EVERY year. And in the next leg of the upcoming deflationary storm A LOT OF pensionfunds WILL go bust. Thereby devoiding some 92 million baby boomers of income. So, there 92 million people who are dying much faster than anyone will anticipate.

    Peak Spending occurs at the age of (on average) 47. And spending drives earnings of companies. After 47 people spend less and save more (or pay down their debt, which is highly deflationary).

  16. I think you may have overlooked immigration. Historically it is overwhelmingly young people of child bearing age. Obama just won the election not so much by white people but by minorities specifically Latino and Asians.