Event Horizon

The day I gave up testing whether markets are efficient or not was a great day. My productivity went through the roof.

Now I assume that the asset I am studying is efficiently priced and that provides a focus for my analysis.

Charlie Munger feels the same way.

The following is from his Art of Stock Picking letter

Everybody goes there [horse track using pari-mutuel betting system] and bets and the odds change based o­n what’s bet. That’s what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so o­n and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it’s very hard to beat the system.

Charlie Munger also provides us with a solution

And the o­ne thing that all those winning betters in the whole history of people who’ve beaten the pari-mutuel system have is quite simple. They bet very seldom.

It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it ‑ who look and sift the world for a mispriced be that they can occasionally find o­ne.

And the wise o­nes bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.

That is a very simple concept. And to me it’s obviously right based on experience not only from the pari-mutuel system, but everywhere else.

Charlie Munger is fortunate to run a closed-end fund.

For the rest of us mere mortals, drawdowns/redemptions are a fact of life (unless you can poke a hole in the space-time continuum).

The death spiral of underperformance-redemptions-underperformance-redemptions is the stuff of nightmares for investment managers.

If not Charlie could God to the job?

Wes Gray proved even God would be fired as an active manager of an open-ended fund.

His study is entertaining and disheartening. Wes is not religious, he defines God as person who, every five years, buys the top five performing stocks over a five year period

In summary, God would generate outstanding performance (29% compounding from 1927 to 2016) but be sacked for periods of underperformance (the worst period -76%).

So if you cannot fill a portfolio with the best performing stocks over a five year period, what do you do to survive?

If I am assuming the market is efficient and I do not have a competitive edge with my valuation methodology I am left tracking the marginal buyer.

But it is not enough to identify the marginal buyer. I need to study the investment time horizon of the marginal buyer.

The Short-Term Marginal Buyer

Most buyers with longer-term investment horizons tend to be active in the market for a limited period. They achieve their portfolio weight and are no longer in the market.

Buyers with a short-time horizon tend to be active in the market for a sustained period and that is why the share price trends.

Buyers with short-term time horizons include quant funds, macro strategy funds and ETFs.

Below is a five year chart for McDonalds $MCD


I have chosen $MCD as its recent share price movement is unlikely the result of ETF activity. $MCD is not a top 25 ETF holding and I do not want to be seen as the last of 20 million pundits to blame ETFs.

If you had held $MCD from September 2013 to September 2015 you would be out of a job.

The market for $MCD during this period was dominated by the long -erm marginal buyer.

In September 2015 $MCD experienced a price surge. The new long-term marginal buyer appeared, the yield hound. The yield hounds were exhausted in a month and the price was flat for calendar 2016.

At the beginning of 2017 $MCD was able to provide a number of knowledge points (international performance, results of menu changes) to attract the short -term marginal buyer. The sustained activity of this short term marginal buyer has created the upward trend of 2017.

So what does this mean for portfolio construction?

Is it possible to construct a portfolio purely on the basis of arbitraging time horizons?   

Every investment manager needs the luxury of outperforming early.

If you outperform early you can get on with the business of being “true to label”.

What companies are more likely to attract the short-term marginal buyer?

The greater the frequency of knowledge points the shorter the time horizon of the marginal buyer.

It may appear odd that you could generate outperformance from a company that is constantly in the news…..but…..if you are the only long-term player in a sea of short term players the odds are in your favour.

Most would assume the market for Apple $AAPL is efficient. To the short-term marginal buyer it is a simple, single product company with plenty of knowledge points (product launches and quarterly updates).

Below is a 24 month chart of $AAPL. I have chosen 24 months to accommodate the ETF effect of 2017.


Calendar 2016 provided numerous opportunities to arbitrage the short-term nature of the $AAPL market.

Does Amazon $AMZN attracts the same marginal buyer?

$AMZN does not attract a raft of homogenous short term marginal buyers.

The $AMZN marginal buyer is a mix of Bezos disciples (long term), FOMO investors (medium-term) and short-term buyers.


Calendar 2016 provided one opportunity to buy $AMZN and that was when the US market dipped.

This framework applies to other asset classes

The marginal buyer in infrastructure is a mix of long-term and short-term marginal buyers therefore providing little opportunity to outperform.

In property, there are regular periods where the short-term marginal buyer of commercial property dominates therefore presenting opportunities for time horizon arbitrage.

When you are looking at horses, don’t think you are Charlie Munger, assume you are the stable hand.

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