LOM Weekly Perspectives

In U.S equity markets, year-to-date, the value style of investing has beaten growth. In fact, value has outpaced growth since the tech debacle in 2000. We are not, of course, referring to shorter periods in the past two years in which careful timers could have made money moving in and out of some technology stocks -- for example, in the fourth quarter of last year, or taking advantage of run-ups in sub-sectors such as semi-conductors. But over the whole time span, the tech sector was one to avoid. Yet, there is lingering hope among many investors that some day soon the sun will shine on the technology sector. Its fate is of course tied to the prospects for capital spending which shows few signs of rebounding vigorously. In many cases, rich valuations are already discounting a good pickup in earnings growth. Taking a longer perspective on the tech sector, after the boom phase of the nineties and the destruction of the last two years, we are likely to see a period of consolidation in the next few years in which some major winners will emerge -- along with a good deal of attrition.

One of the troubling issues that continue to hang over financial markets is the uncertain outlook in the Middle East. The lack of an effective U.S. foreign policy is raising concern among allies, both in the Middle East and Europe, and compromising the war against terrorism. Financial markets want to see some semblance of resolution and stability on the horizon, not more crises. Investors don’t like the risk of oil price spikes or an unstable Saudi Arabia. Furthermore, intervention in Iraq to remove the Saddam regime appears to be firmly on the Bush administration’s agenda. Their thinking is that it is possible to repeat the Afghan success in Iraq. But it is a risky undertaking, and if it goes wrong it can further destabilise markets and the global economy. Removing Saddam Hussein from power may be a laudable act but the timing must be right. He is an accomplished survivor, not least because his ostensible enemies have often helped to keep him in power. The Gulf War provided an excellent opportunity to destroy his regime, but the United States and Saudi Arabia refrained from doing so, fearful of being able to control the succession and wishing to keep a balance of power in the region.

A trademarked advertising message used by the ACE insurance group reads as follows: "Take away the risk and you can do anything". A nice promise, except that it’s false. What they mean to say is that you can hedge some of your downside risk via their products and services. In fact, if risk is taken away you can’t do anything. Everything will be predetermined. Choice entails risk. In a deterministic world, the future would be known. There would be no risk and no choice. What an awful prospect! To save the day, Barra, who provide fancy software to investment professionals, have come up with their own words of wisdom (stamped with a trademark, naturally): "Risk is good". Tell that to the folks still reeling from the tech crash. At least Barra was good enough not to comment that "you can do anything with risk" or that "more risk is better than less". Hey, their audience is made up of sophisticated investment types.

Actually, hoping not to sound too ponderous, risk is the most important word in the investment vocabulary. The understanding, calculation and control of risk are critical to successful investment strategies. It is important even for speculators, who are often regarded as being undisciplined with their money. In fact, the more accomplished among them are more careful risk controllers than many a mutual fund manager. So it is with good hedge-fund managers who are diligent about risk control and only make calculated bets. Any miscalculation and the market will mete out a merciless punishment. You mention LTCM? Well, their problem was that they became too enamoured with their quantitative models. The models are as good as the people who handle them and their ability to exercise critical judgement, which is often in short supply among the horde of mathematicians and physicists who have found a new home in finance.

Meanwhile, some of the other major factors in superior hedge-fund management are good timing, speed and expertise in identifying exploitable inefficiencies. It takes a lot of skill to find inefficiencies because the market is not known for its largesse in allowing easy money to be made. Where there are significant inefficiencies, there are also higher concomitant risks. Quantitative models have their place in sorting out opportunities and risks. But of equal importance is a qualitative understanding of institutions, organisations and the psychology of the market. Relying on mechanistic quantitative methods without the use of judgement can be seriously misleading. An accomplished practitioner such as George Soros takes care in considering qualitative factors, along with the "quants". Some of his most celebrated coups, such as the highly successful bet against sterling illustrate this point very well. The result depended on an accurate reading of the expected reaction by the Bundesbank and the Bank of England.