Renaissance's Skill and Facebook's Buyback
The big problem with Renaissance Technologies, the Long Island-based "pinnacle of quant investing" founded by Jim Simons, is that its Medallion fund makes too much money:
Simons determined, almost from the beginning, that the fund’s overall size can affect performance: Too much money destroys returns. Renaissance currently caps Medallion’s assets between $9 billion and $10 billion, about twice what it was a decade ago. Profits get distributed every six months.
Medallion was up 21.0 percent for the first six months of 2016. It was up 35.6 percent last year, 39.2 percent the year before, 46.9 percent the year before that. This keeps going. The last down year was 1989. The fund had a rough few days in August 2007, but ended the year up 85.9 percent. It has returned about 40 percent per year, on average, net of fees, since it started in 1988. But it can't compound at that rate. It keeps handing money back to investors, because it has too much. If Renaissance had started 2007 with $5 billion, and had had the actual performance it has had over the last decade, but without returning money to investors, it would have $214 billion now. That's too big. In actual fact, it keeps handing back the money, and "has produced about $55 billion in profit over the last 28 years."
Good job, everyone! Renaissance has, probably more than any other hedge fund, discovered the secret of investing. But if you climb the mountain -- or drive to East Setauket -- and are admitted to the presence of its gurus, and you ask them the meaning of life, they won't really have a satisfying answer for you. It's more this sort of thing, from Renaissance co-head Peter Brown (who "usually sleeps on a Murphy bed in his office"):
“It turns out that when it’s cloudy in Paris, the French market is less likely to go up than when it’s sunny in Paris,” he said. It wasn’t a big moneymaker, though, because it was true only slightly more than 50 percent of the time. Brown continued: “The point is that, if there were signals that made a lot of sense that were very strong, they would have long ago been traded out. ... What we do is look for lots and lots, and we have, I don’t know, like 90 Ph.D.s in math and physics, who just sit there looking for these signals all day long. We have 10,000 processors in there that are constantly grinding away looking for signals.”
"Signals that made a lot of sense that were very strong" are what Renaissance is not looking for. Investing wisdom that you can sum up in a sentence, or a paragraph, or a book, or a human lifetime of learning and understanding: That's not for them. What they want are signals that don't make much sense, that aren't very strong, that you can't grasp intuitively and then go out and implement. They want stuff that looks like noise, but that in the hands of a powerful enough computer with cheap enough implementation costs, can make a little bit of money. Over and over again.
And so Renaissance doesn't really hire people because they understand investing. "A résumé with Wall Street experience or even a finance background was a firm pass" early on at Renaissance, and it's full mostly of speech-recognition specialists and astrophysicists and string theorists, scientists who "excel at screening 'noisy' data." It's a pattern-recognition firm, a data-processing firm, a firm for finding correlations and signals and using those signals to make frequent, tentative, marginally profitable decisions. Which add up to 40 percent annual returns, year after year.
It's a little embarrassing, no? That investing is best understood by people who don't understand investing? That it's a trivial application of broader data-science principles, best addressed by people who were trained on harder and more interesting applications? Anyway, I highly recommend Kathy Burton's Bloomberg Markets profile of the firm, which also mentions the company legend that "on one of the firm’s ski trips, Simons, a longtime smoker, bought an insurance policy for a restaurant so he wouldn’t have to forgo his beloved Merits."
Elsewhere in hedge funds.
There are other approaches! You can do deep fundamental research on a few companies, buy the ones you think are underpriced, short the ones you think are overpriced, and try to effect changes at the companies that will make your investments more valuable. That is not working especially well for Bill Ackman and Pershing Square Capital Management at this precise second, but that too is an opportunity:
“You can buy Pershing Square today and we’re really cheap,” he told Andrew Ross Sorkin of The New York Times at the conference last week. “And then you get the benefit of the same management team with that much more humility, that much more insight and experience.”
Wouldn't it be great if he raised his fees? I mean, if the team was worth a 1.5 percent management fee and 20 percent of profits before, surely that same team with more humility is worth at least 2.5 and 20?
At that same conference, Ackman expressed confidence that, in a Trump administration, Fannie Mae and Freddie Mac will escape the comfortable limbo of conservatorship and be returned to their rightful owners, including Pershing Square. I was a bit skeptical, since Trump and his advisers don't seem to think of government-sponsored enterprise reform as a top priority. But why not? John Paulson, another big Fannie/Freddie investor, is also a Trump adviser, and has been lobbying hard for re-privatization. The "common-class shares soared more than 80 percent since Election Day." That's a signal that does make intuitive sense -- albeit a bit buried in the noise of Trump policy proposals -- and that is very strong, but it's also one that can be helped along by the hedge funds' own actions. The quant funds have only interpreted the financial world in various ways; the point of activist investing is to change it.
Elsewhere, here is the 2016 Proskauer Annual Review and Outlook for Hedge Funds, Private Equity Funds and Other Private Funds.
The way business works is that you make stuff, which costs money, and you sell stuff, which makes you money. Then you take the money you get from selling stuff and use it to make more stuff, which you sell to get more money. And so forth. Money goes out, and money comes in, and money goes out again.
One specific way this might work is that you could find $10 in your couch cushions, and use it to make your first widget, which you sell for $12, and reinvest that money in making 1.2 more widgets, and keep going in a perfect virtuous cycle in which your future cash needs always exactly match your past cash generation. That's very convenient! But it is also sort of a strange coincidence. Most of the time, a business will need either more or less cash than it happens to have generated from its business. This is why there are investors. A business might sell a few widgets, see a massive market opportunity, and want to build a big widget factory that it can't yet afford. So it borrows money from investors to build the factory now. Then, once its big widget factory is operating efficiently and it's selling a lot of widgets for a lot of money, it might not need all that money to produce more widgets. So it gives the money back to the investors.
People understand the first stage pretty easily. When companies borrow money, or when they do initial public offerings to raise cash from investors, people are like "oh, right, they need money to build their widget factory." But the second stage seems to bother people, for reasons that I don't fully understand. When a company makes a massively profitable product with negligible marginal cost, and generates lots of cash that it doesn't need to make more of the product, and gives the money back to investors -- there are complaints. "What is that company doing giving money back to investors," people ask. "Shouldn't it be investing it in building more widgets?" But: Why? It would be a strange, random coincidence if every company always needed to spend exactly the money it generated. Sometimes companies have too much money. Shouldn't they give it back to the people who gave them money in the first place?
When Facebook did its initial public offering, I pointed out that even then it didn't need the money it was raising. (To be fair, Facebook pointed that out itself; the "Use of Proceeds" section of the prospectus was basically a shrug.) Now it has announced a stock buyback program that, if completed, will return almost as much money to shareholders ($6 billion) as Facebook actually raised in that IPO ($6.8 billion). Facebook has about $26 billion of cash and marketable securities. Its operating cash flow over the last nine months has been about $9.8 billion. Also: It is a website. Marginal costs are low. Yes, I know, Facebook has to build drones and buy competitors and reconfigure our reality and do all the usual stuff that social media companies are supposed to do. But it really would be surprising if it needed all of the cash it has ever generated to do that business.
It's not weird that Facebook is giving some money back to shareholders. It's not an admission of defeat, or a confession that Facebook is out of ideas. It's not a sign of short-termism, or of capitulation to Wall Street interests. It's not stock manipulation, or earnings-per-share management. (Though it does concentrate Mark Zuckerberg's voting control a bit.) It is just the absolutely normal expected thing for Facebook to do: It has made a ton of money, and doesn't need all of it, so it's giving some of it back to its owners.
Early Facebook trained you to remember birthdays and share photos, and to some extent this trained you to be a better person, or in any case the sort of person you desired to be.
The process that Facebook currently encourages, on the other hand, of looking at these short cards of news stories and forcing you to immediately decide whether to support or not support them trains people to be extremists.
"Italy's banks are a slow-motion emergency," not exactly collapsing, but full of troubled loans and cautious about lending more. Iranian banks are more hopeful, "trying to fall in line with international standards of transparency so they can better attract business and integrate with the global industry." Credit Suisse Group AG's Swiss bank is "relatively boring -- in the good sense," so it's going to do an initial public offering next year to strengthen the parent's capital position.
Meanwhile, U.S. bank regulation is a total mystery. "Incoming Senate Minority Leader Chuck Schumer, drawing a line in the sand for the next administration, said he has the votes to stop President-elect Donald Trump from repealing the Dodd-Frank Act and 'the rules we put in place to limit Wall Street.'" And: "Executives at Wells Fargo & Co. over the weekend were grasping to understand more-stringent management restrictions newly imposed on the bank by the Office of the Comptroller of the Currency." There is a "keep 'em on their toes" theory of bank regulation in which unpredictable regulations are harder to game, so banks may just throw their hands up and say "fine, we don't even understand what the rules are, so we'll just have to act honestly and ethically and stay away from gray areas." I do not think that is a fully plausible theory of bank regulation, but you can see the appeal. I suspect it will be tested in the next few years.
In the model, financial intermediaries choose to invest in the lowest risk assets available in order to issue safe securities while minimizing their reliance on equity financing. Although households and intermediaries can trade the same assets, in equilibrium all debt securities are owned by intermediaries since they are low risk, while riskier equities are owned by households. The resulting market segmentation explains the low risk anomaly in equity markets and the credit spread puzzle in debt markets and determines the optimal leverage of the non-financial sector. An increase in the demand for safe assets causes an expansion of the financial sector and extension of riskier credit to the non-financial sector -- a subprime boom. Quantitative easing increases the supply of safe assets, leading to a compression of risk premia in debt markets, a deleveraging of the non-financial sector, and an increase in output when monetary policy is constrained.
On Friday, U.S. president-elect Donald Trump agreed to pay $25 million to compensate people who were defrauded by his fake university. Ivanka Trump, who will help run her father's businesses while he's president, also gets to sit in on his diplomatic meetings. Trump's business partners in India flew in to meet him and discuss further Trump branding opportunities. "Under president Trump," writes Felix Salmon, "it is scarily possible that the U.S. could become Kenya, and that power will be centralized in a White House where loyalty is valued above everything else." And Trump's chief strategist Steve Bannon is, to my knowledge, the first major American political figure to explicitly cite Satan as a role model:
"Darkness is good," says Bannon, who amid the suits surrounding him at Trump Tower, looks like a graduate student in his T-shirt, open button-down and tatty blue blazer — albeit a 62-year-old graduate student. "Dick Cheney. Darth Vader. Satan. That's power. It only helps us when they" — I believe by "they" he means liberals and the media, already promoting calls for his ouster — "get it wrong. When they're blind to who we are and what we're doing."
Oh and research analysts expect Trump to "Make X Great Again," for every X.
People are worried about unicorns.
You know who is worried about unicorns? Steve Bannon:
"That’s what the Democrats missed, they were talking to these people with companies with a $9 billion market cap employing nine people. It’s not reality. They lost sight of what the world is about."
He is not wrong! If your model of the world is that unicorns are imaginary creatures who bring imaginary treasure, that will serve you reasonably well in thinking about private tech companies that create billions of dollars of stock-option riches for tiny groups of programmers and executives without manufacturing things or employing many people.
Elsewhere: "Sesame Ventures, the venture fund formed by Sesame Workshop and New York-based Collaborative Fund in May, has made its first investment in a tutoring platform called Yup." Yup is pretty small, certainly not yet a Muppet Unicorn. Nonetheless I expect that someone will draw me a Muppet Unicorn tutoring someone in math.
People are worried about stock buybacks.
I have already given you my usual rant about stock buybacks under the heading "Facebook buyback," supra. But there's more in the vaguely buybackish vein. Here is "Can America’s Companies Survive America’s Most Aggressive Investors?" (Activists are pushing buybacks, short-termism, research cuts, you get the idea.) And here is Christopher Mims on research and development:
Support from the federal government has waned, from nearly 2% of gross domestic product during the 1960s to about 0.6% today. Over the same time, corporate R&D has grown to nearly 2% of GDP, from less than 0.6% of GDP in the age of the Apollo program.
Sounds fine, right? But 1960s-era government R&D tended to fund basic research that led to big breakthroughs; "most modern corporate R&D, by necessity, focuses on the other end of the pipeline, bringing to market things that are ready to be commercialized."
People are worried about bond market liquidity.
There are a lot of reasons to worry about Donald Trump's presidency and, sure, why not, bond market liquidity could be one of them:
In the week after Donald Trump’s U.S. election victory, investors pulled more cash out of U.S. fixed-income funds than at any time over the last three years, in one early sign that the recent bond selloff may have legs.
Big selloffs in bond markets often go hand in hand with investors taking money out of mutual funds. This can create a vicious cycle, whereby selling begets more selling.
"We may not be at the start of a 35-year bear market for bonds, but it feels as though we’re at some kind of inflection point," says a guy.
I wrote about JPMorgan's China hiring practices.
Tokyo relaunches bid to become top financial centre. China’s Influence Grows in Ashes of Trans-Pacific Trade Pact. Venezuela’s Nemesis Is a Hardware Salesman at a Home Depot in Alabama. Euro, Dollar Flirt With Parity. Theresa May Wants Business to Change Capitalism. Dallas Stares Down a Texas-Size Threat of Bankruptcy. "Actively managed global equity funds outperformed the market by between 1.2 per cent and 1.4 per cent annually on average between 2002 and 2012." Europe Needs Its Own Banking Regulations, Deutsche Bank CEO Says. Bitcoin Users Who Evade Taxes Are Sought by the I.R.S. As I often point out, the optimal tax is one on foreigners living abroad. Insurer Anthem to Defend Cigna Deal in Court. Microsoft is working on a quantum computer. Behind ‘League of Legends,’ the Chinese Giant Plotting Global Domination. "I have life-insurance coverage that includes skydiving, but I didn't specifically ask if they covered jumping without a parachute." Bad sex writing. Octopus in the parking garage is climate change’s canary in the coal mine. "A food company we met with invested significant sums in new processing facilities that employ novel processes for China, and manufacture a new category of meat product not previously in existence."
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