Weekend Reading #28
This is the twenty-eighth weekly edition of our newsletter, Weekend Reading, sent out on Saturday 3rd August 2019. To receive a copy each week directly into your inbox, sign up here.
Our approach to money management.
Transparency has become a corporate buzzword. But in the old school world of investment management, it’s still a thing of rare beauty.
Of course, investing should be a transparent process. That’s obvious, since in order to build trust with investors and get them to part with their cash, we need them to understand precisely how we make money.
Managers must be 100% accountable to stakeholders and investors. The process must be followed at all times. Times of high stress are not the time to throw process out of the window and go with your gut – in fact, process becomes even more important when the going is tough, providing much needed structure and perspective.
Many managers simply don’t get it. They don’t understand that transparency is their best friend, conditioning them to stick to the plan and generate returns that are replicable and sustainable. The more eyes monitoring whether the blueprint for managing money is being followed, the lower the chance of deviation from the roadmap.
That is why when we launch our fund, our investment process and our trading activity here at Three Body Capital will be made available to investors at the end of every trading day, if they so desire, subject to non-disclosure agreements.
In that spirit, we’re releasing to our entire community the principles around which we plan to manage our investment products. This document is a living thing – a continuously updated framework that we can refer to and that everyone can monitor and have input into, specifically in terms of managing risk and capital allocation.
One caveat to all this – short positions, by their very nature, are highly sensitive. So details of these will only be provided on-site in our offices to existing investors.
Three Body Investment Principles.
Don’t lose money.
Don’t forget rule #1.
Only be exposed to a controllable number of positions.
Only be involved in simple, liquid, vanilla instruments.
Always be able to liquidate the portfolio to cash at short notice.
Acknowledge that at any point in time, there are multiple paths that stocks and markets can take, and that some of these paths may be diametrically opposed to each other.
Expect to get it wrong a lot – particularly from a macro perspective – and preemptively plan how to mitigate this each time.
Manage money like it’s our own, like we can’t afford to lose it.
At the end of the day, our primary objective is to deliver 8% p.a. net of fees. It is not NOT to provide long-term exposure to the market or to any individual stocks. Yes, we use investment themes to guide the process because we believe this approach gives us our best chance of achieving these returns and we identify with narratives. But we are not ideologically wedded to any individual themes or positions: they are simply a means to an end.
Ideas are a dime a dozen, and we have lots of good ideas (and many bad ones, too). But that doesn’t necessarily mean that ideas make us money all the time: the trading and investment process are what will deliver us our performance.
Our aim is to increase the value of the portfolio over time: absolute portfolio returns net of fees are what we seek. The only way to achieve this is to avoid large drawdowns, and the only way to avoid large drawdowns is to cut risk early.
This approach has traditionally been criticised by managers, largely due to high trading friction and associated costs: “If I cut the position too early, I lose the upside potential and if I trade too often, I am wasting client money.”
But times have changed, and the maturation of the market presents managers with an opportunity to benefit from a more proactive and dynamic approach to managing risk. With the costs of trading approaching zero, we can always put risk back on rapidly if we’re wrong.
At all times, we seek to remember Rule #1, taking care of the downside and letting the upside take care of itself. There are more than enough opportunities in any given period for us to earn our returns, provided we don't endure large drawdowns.
Our process fully embraces charts and narrative monitoring. The market is a cacophony, with conflicting stories broadcast at maximum volume, 24/7. These stories and narrative lines are what link company fundamentals to the stock price.
Earnings Per Share x Earnings Multiple = Stock Price
Fundamentals x Sentiment/Narrative = Stock Price
Fundamentals are just one part of the picture, albeit an important part. But they are not the entire picture, and they certainly do not single-handedly determine the stock price.
We invest in stocks, not companies.
In order to solve for how fundamentals translate to stock price, we need to know who the market participants are. Who else is at the table with us? Who are we trading against? If we don’t know, we don’t participate.
Even if we know who’s at the table, that composition doesn’t stay constant. People come and go, conditions change, information is incomplete and new information is continually revealed. Things change, and failing to change accordingly is dangerous. We change our minds as new information presents itself – which is also why we don’t like making single-stock proclamations as the basis of future performance.
The key ingredients of our process are as follows:
Long term fundamentals – telling us whether there is a transformative opportunity long/short in a certain stock.
Short-term fundamentals (news, results, sentiment) – telling us the near-term trajectory of the stock’s operational performance, tracing out steps in the long-term view.
Charts – telling us what the market currently thinks about the stock, helping us to identify breakout and breakdown levels.
The key output of the process is to understand the small play as it relates to the big play – recognising that there are multiple paths a stock price can take at any point, and that the near term trajectory could be in the opposite direction to the long-term one.
Given the uncertainty in markets, especially with direction and momentum, we aim to make small, “base” returns every year through consistently active trading and exploiting small pricing dislocations.
This allows us to have a very good feel for market movements and sentiment, and exploit the few big opportunities to make outsized profits as and when they present themselves. These large opportunities typically congregate in a sweet spot of fundamentals, favourable charts and narrative.
When the stars align, we take larger positions and run them for maximum return, still subject to strict breakdown/breakout levels but with more flexibility, given the asymmetric opportunities we envisage.
We aim to deliver for our investors a reasonable return every year, on a consistent basis. The aim is NOT to hit the ball out of the park every year. For sure, our process maximises our chances of locating opportunities to do so over time, but the timing of their appearance is not predictable.
The best trades are asymmetric in terms of risk and reward. We aim to run our winning trades all the way home, but our losers are subject to very strict stop loss criteria.
The biggest opportunities for profit in transformative stocks typically arise as a result of big shifts in market direction and big outright market moves. As we see in most cases, because of an outsized, extreme move, risk/reward was sufficiently skewed one way for us to make a significant return at much lower risk exposures.
Shorts are a critical ingredient in our investment philosophy and process. They not only allow us to take advantage of market moves to the downside, but the ability to take short positions informs a much broader view of the opportunities present in the market.
Shorts are an opportunity for us to generate alpha and we aim to make money from every short position.
While extreme emphasis has classically been placed on identifying good long ideas and how to manage them, it has less so been the case with short positions, thanks to an unfounded unpopularity around “evil short sellers” causing companies to crash. The reality is that no single short seller could ever cause a well-run company to collapse: even short sellers are bound by the fundamentals of investing, and fundamental reality always wins in the end.
In contrast, the overriding narrative has always been that markets generally go up, as has been true in the post WW2 era. We believe that investors need a toolkit and playbook for what happens when markets do not just continue to go up. We believe the world is changing exponentially and that short selling is a critical part of managing the risks that accompany these changes.
Whether long or short, we do not get ideological about positions. What is a long today might be a short tomorrow, and vice-versa, under different and rapidly-changing market environments. We’re here to make money, not to pass judgement.
While we are certainly not style agnostic, we likewise do not believe that a single style necessarily leads to long-term success. In that sense, while our process of identifying transformative companies centres around the growth aspect of companies’ earnings and optionality, we are loathe to classify ourselves as a “growth” investor. Nor a “value” investor, nor a “momentum” investor.
Not only do we find such classifications an oversimplification of the complexities of successful investing and the eclectic skillset required to achieve it, we believe they restrict the manager to success in one specific type of market.
Nonetheless, such an approach conveniently appeals to the logic of “asset allocation”, where allocators constantly tweak their allocations across not just asset classes, but across styles, an approach popularised by the “factor investing” by Fama and French.
We do not wish to receive allocations from investors on the basis of the style or region du jour – we seek to earn allocations based on our ability to deliver absolute returns over time.
As a result, we must be able to invest under ALL conditions - although to be clear, this doesn’t mean we need to be invested AT ALL TIMES. Instead, we will tailor our approach and processes to adapt to the prevailing market environment. If we head into a 5 year global bear market, we believe we’ll be able to make money from investing on the short side.
Again, the focus is on absolute portfolio level returns net of fees – nothing else.
Dealing with losses.
As we mentioned earlier, the only way to avoid large drawdowns is to cut losses early and prevent them from getting too big. Key to enforcing that discipline is the use of stops, both on individual positions and on the portfolio in its entirety.
With trading positions, stop losses need to be extremely tight, especially when these positions are put on to test the pulse of the market. In this way, we are able to make a large number of trades, getting strong visibility on market conditions, with at worst limited losses.
At the portfolio level, we consider the starting NAV at the beginning of each full performance accounting year to be the new zero mark, below which we set a 5% hard loss limit. We start every year with the view that we only want to have core and trading positions that carry momentum in our favour - especially since our 0% management fee model does not oblige us to hold anything at all.
For core positions, stops are set as a function of key breakdown/breakout levels, which suggest that on balance, our assumptions about the state of the stock/market may be wrong. Likewise, we wait for momentum to be confirmed by breaks of key levels up and down to cut or grow positions.
For example, with CD Projekt (CDR PW), we have clearly defined breakout and breakdown levels. Falling below 200 threatens a crack in underlying momentum, necessitating a 50% reduction in the position upon a break. Breaking above 220 signals potential upside towards 300, suggesting a 50% increase in position size to capitalise on the breakout was appropriate.
Take profit levels.
Having defined and limited our downside risk, we must define where we start taking profits (particularly on shorts).
As is the case with stops, key levels can be identified in advance of putting a trade on, where we expect even long-term structural trends to take a pause. It is at these levels where we would expect temporary reversals both up and down, and where – if levels are hit – we would look to take profit on large proportions of an open position. This is especially true if a stock moves in our favour very quickly in a short span of time. The quicker the move, the more aggressively we book our profits.
With stocks that are trading within historical ranges, identifying these key levels is a matter of referring to breakout and breakdown levels encountered in the past, since it is at these same levels where bulls and bears in a particular stock are most likely to encounter each other in the highest volume (bulls expect breakthroughs, bears expect pullbacks). As a result, profits made up to those points should be taken, and risk put on only after the up/downtrend has been clearly resumed.
With stocks that break out of their historical trading range (both up and down), we tend to run positions to achieve maximum upside (more so on longs). Once more, the aim is to maximise return subject to a constraint of minimal risk.
Never forget: we are trading in stocks – not companies.
Given the active nature of our management process, we tend to avoid having outsized trading positions in markets that are closed during our working day.
As a result, markets like Chinese A-Shares (closing at 7am/8am UK time) will have much smaller exposures than markets with more significant time zone overlap in Asia (e.g. Indonesia and India), Europe and the Americas. This applies both for trading exposures and core positions, purely as a function of our ability to manage and monitor risk.
It’s easy for managers to make claims about the efficacy of processes and policies with hindsight – the evidence that a process has worked in the past is in the track record.
The more important question for an investor, however, is this: will a manager actually stick to these policies, especially in times of extreme market stress? And how will a manager be held accountable for whether process and policies are adhered to?
For most managers, the answer to this is a regular update, reporting logs, customised reports, portfolio look-through etc. These monitoring tools are important, and we shouldn’t subtract from the value that they provide in terms of diagnosing and identifying problems. Yet these diagnoses are after the fact – they are used to identify where things have already gone wrong.
We are interested in preventing things from going wrong in the first place. As a result, we choose to live and die by our performance, because we believe that our process and policies not only help us to make money, but also prevent us from chalking up outsized losses, sticking to them is the surest way of consistently growing absolute portfolio value.
Absolute performance is the only metric we will ever look to be paid for. No management fees, no backup plans, no “1 or 30”. Just a share of profits and a high watermark every year.
Because we live and die by our investment performance, we are more incentivised than anyone else to adhere to process, especially on risk management, with checks and balances both internally (embedded in the investment process) and externally (independent risk oversight and authority to execute a portfolio level stop loss).
We are also happy to be transparent with these processes, making our strategy, mandate and policies available for public scrutiny, along with constant communication with investors via our weekly newsletters.
Our personal money will be in the funds we manage, along with that of our friends and families. We not only manage our investors’ money like our own – we manage it alongside our own.
Finally and most importantly, the only way to understand our business truthfully and deeply is to understand WHO we are, both as a team and as individual human beings.
One of the most astonishing things we have found in our investment careers to date is the lack of questions from allocators about who we are as people. The single most important thing when investing is to understand what makes the people behind the business tick. What are we excited about when we get up in the morning? What is our family life like? What do we do in our (somewhat limited) spare time? What do we do for fun? What do we like to read? To watch? To listen to? What are our personal histories? How do we know each other? Why did we choose to have this conversation in the first place?
There is no such thing as a bad question and we encourage all of our potential investors to ask away if there is something they want to know. If smart, busy people are willing to take the time to understand what makes us tick, we’re confident they will back us.
What we're doing.
This week we spent some time exploring deals for our professional investor network. This is a REALLY fun part of our work here at Three Body Capital. In fact, it doesn’t feel like work at all.
In recent weeks we’ve been out and about meeting with ambitious entrepreneurs to really get to grips with their businesses and understand if they might be relevant for our audience. And it feels like we’re making real progress with sourcing the right kind of opportunities.
From clean energy companies with operations in the UK and Indonesia, to technology companies in Poland, to crypto infrastructure providers in Africa, the mix of businesses and founders we’re connecting with is eclectic and representative of the incredible potential we see in emerging markets as they pursue transformation.
If you’d like to receive an invite to our professional investor network when it launches in the coming weeks, please hit “reply” and drop us a line.
What we're listening to.
Untold Stories is a brilliant podcast. This week we caught the episode in which Charlie Shrem chats to Binance’s CZ. It's an unfiltered, behind-the-curtain look at the crypto's past, and a glimpse into its future.
Binance is an incredible company, and it could just be one of the biggest game-changers of our generation. What’s undeniable is that it is THE market leader when it comes to crypto exchanges space and provides a blueprint for how the crypto infused, “tokenised” future might unfold.
Binance is crypto’s first blue chip. In the future, business school case studies will be written about this company and it’s inspirational leader.
A fun listen this week was Rob Reid’s The After On Podcast, in which he spoke with Quantitative Psychologist Don Hoffman to get a head-spinning take on the true nature of reality. Truly mind-bending and a welcome break from the ordinary whilst commuting to work!
We've also been listening to Gimlet Media's Without Fail, which hosts candid conversations with people who have done hard things. In this episode – entitled "The Tragedy Expert" – Alex Blumberg talks to Kenneth Feinberg, who in the days after September 11, 2001, took on an unenviable task – figuring out who should receive money from the September 11th Victim Compensation Fund, and how much they should get. Now, nearly two decades later, he’s still the person we turn to in the wake of our worst catastrophes.
We came across this little gem through The Profile, Polina Marinova's weekly newsletter looking at how high-proofing figures become successful, and what makes them tick. You can sign up here.
What we’re reading.
This week we dipped into vegan burger maker Beyond Meat’s offering prospectus. Yep, that’s right, there is another prospectus to get your teeth into. And to be honest, this one tastes rather peculiar.
The stock fell sharply after the company told shareholders it would be selling another chunk of stock, just 2 months after one of the hottest IPO in years. 3 million shares will come from stockholders and 250,000 new shares will be issued at a price TBD.
But what’s really interesting about this move is that the post-IPO lock-up period – originally set to expire in late October – has been waived by the banks that underwrote the deal, allowing insiders to dump shares ahead of time.
This is a great example of skin in the game, or the lack thereof. We’ve lost count of the number of high profile entrepreneurs loading their companies up on debt and/or looking to cash out before IPO. Yes, it’s a natural part of how markets work, but the style in which it is done says a lot about people and the companies they work for.
We live in a world where accountability is diminishing by the second. So when you find people with skin in the game, hold them close. They're special.