Active Investing in the Age of Disruption. Evan L. Jones
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mission.
Information is of value only if investors have a very clear understanding of their investment process and what is truly informative to an investment decision. A detailed, disciplined investment process is necessary to organize the information and decide on its value in the context of each investment.
The first reason for writing this book is to step away from the tasks of day-to-day investment management and think about the investment process and the broader scope of the financial markets. Hopefully, introspection offers the opportunity to think about what data is important and what data is extraneous and answer the questions of how, when, and where the constant stream of data should be used to create superior returns. Additionally, the broader challenges facing active investment management today and how they might be affecting the execution of the investment process may be contemplated.
What were the challenges in the 2010s?
How will the 2020s be different?
Why has active investing alpha declined significantly since 2010?
How can the challenges be met?
The environment created by global central bank intervention has had many derivative effects and made active investing in the 2010s more difficult than ever; this will continue in the 2020s. Global central banks have taken center stage, capital is cheap to everyone, and momentum is a driving force in the financial markets. Refocusing on defining and executing the key investment tenets that will lead to significant outperformance is necessary to meet this challenge. Throughout this book, I define significant outperformance as averaging 1,000 basis points of alpha per year measured on a three-year rolling basis. No one can outperform every year, and the best time frame to judge an investor is five years, but a three-year rolling basis is a fair measurement. This is a lofty goal. Few managers achieve this goal and the number that do is dwindling every year. In fact, fewer and fewer managers are even getting the chance to try, because institutional allocators are moving more capital to passive investing each year.
For me, process is the key to success despite it often seeming boring and, to many who do not see the subtleties, the same. These subtleties to the investment process make a huge difference when the margin of error between under- and outperforming is so thin. Writing this book is a pursuit to further organize my own thoughts and ideas on how to optimize the investment process and understand the current environment.
You never really know something until you prepare to teach it.
My secondary career activity since 1998 has been teaching at Duke University. I taught entrepreneurship for ten years and more recently endowment investment management, a class in which many members of the Duke University management team participate. My experience in teaching has made it clear to me that organizing your thoughts to teach someone is a great learning process. No one wants to step in front of a class of young, intelligent students without being prepared, so teaching is a constant challenge to keep learning and to understand every aspect of the subject well enough to explain it to others. Trying to communicating my thought process in this book furthers my own understanding.
While we teach, we learn.
—Seneca, philosopher
I have been very fortunate to have had diverse business experiences, which have allowed me a somewhat unique perspective as an investor. Roles as an investment banking analyst, entrepreneur/CEO of a consumer business, micro/small cap hedge fund manager, and global endowment investor have progressively made my scope of business knowledge become broader and more strategic. However, my early hands-on experience running a company, selling product, and managing employees are instrumental in my daily thought process as an investor. Running and selling my company (however small in the context of the broader markets) enabled me to understand intimately many issues that play out in public companies every day. Whether it be understanding the cultural changes that occur in an acquisition, how large global brands manage their distribution channels, or the struggle to provide superior customer service to hundreds of thousands of customers every year, my operational experience colors my investing beliefs and decisions. This early decade of my career led me to a firm belief in fundamental cash flow investing and in thinking about stock ownership through the lens of a business operator.
Moving from the operational stress of running a small business dealing with thousands of individual customers daily to cofounding a micro/small cap hedge fund was my transition to being an investor. I started to define my thoughts on process and alpha creation in the earliest days of working to define our firm's edge for potential investors. My partner and I met with hundreds of management teams on site visits and at industry conferences. These experiences in security selection and portfolio management on both the long and short side were instrumental in the evolution of my investment process methodology. Managing the firm over a seven-year period, we enjoyed every successful investment but learned even more from each mistake. A five-year successful track record was very abruptly interrupted beginning in late 2007.
Painful errors teach you more than success does.
—Jeremy Grantham, investor
Managing a portfolio of micro and small cap companies through 2008 was learning at a level I hope I never get to experience again. I look back on many of my investment mistakes without much acrimony and recognize the value of the lessons learned, but the second half of 2008 was extreme. Many of our portfolio companies were down 50% by August 2008 and as our investors called capital from us to shore up their cash holdings we sold many of our micro-cap ownership positions back to the CEOs and board members in fall 2008, only to watch the stocks drop another 50% in their hands over the next few months. Trying to manage a small cap long and short portfolio during that period was an intense education in the psychological issues associated with portfolio management. We closed the firm down because too many investors were requesting capital, which led me to briefly question all the investment beliefs that had led to the firm's inception.
Fortunately (thankfully), Duke University Management Company (DUMAC) hired me to initiate their direct investing strategy. Since 2010, I have been able to further my education and refine my investment process beliefs by working with the DUMAC team and managing DUMAC's internal capital. Importantly, I have had the added benefit of learning from the strategies and thoughts of hundreds of managers that DUMAC interacts with and allocates capital to every year. The amount of human talent and research data that passes through a university endowment daily is immense and it has enabled me to evolve my thought process globally and across asset classes in ways that would not have been possible at my own hedge fund. Understanding the investment management business from both the hedge fund manager side of the table and the allocator side of the table has offered me unique insight.
This book is primarily directed at concentrated equity investment strategies with lofty goals of alpha creation. The global nature and breadth of diversification at a major endowment often call for a wide variety of investment strategies with different goals. However, the key investment tenets do not change. Understanding the ways investment methodologies can be implemented to achieve predefined risk and return goals through varying concentration levels and across different geographies and sectors has been educational.
I have interspersed quotes from well-known investors throughout the book to, I hope, add credence to many of the points. Reading their books and investment letters were, and still are, instrumental to my understanding and evolution as an investor.
Active investing is a craft that can be honed through experience and research. Of course, luck is an ever present influence in investing. Both good and bad luck influence outcomes and make learning a tricky process. The greatest tools to fight bad luck are a disciplined process and investing with the appropriate time horizon.
It has been a very tough decade for active investment managers. I hope reading this book will help everyone's results in some small way. The 2020s will be successful for those who keep learning and enhancing their investment process.
Evan L. Jones
March 2020
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