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Welcome to Firstlinks Edition 488 with weekend update

  •   15 December 2022
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The Weekend Edition includes a market update (after the editorial) plus Morningstar adds links to two additional articles.

In 1970, one of America’s leading scientists Simon Ramo wrote a quirky little book about his favourite pastime – tennis. The book, Extraordinary Tennis For the Ordinary Player, didn’t sell well initially but has since built a loyal following.

I’ve been a tennis player and fan all my life, so the book has obvious appeal. Ramo’s observations of the game, though, apply well beyond tennis.

Ramo suggests that tennis isn’t one game but two. Yes, players have the same equipment, rules and attire and conform to the same etiquette. Yet that’s where the similarities end. According to Ramo, there’s one game played by professionals and another game played by the rest of us.

Ramo thinks the outcome of an amateur tennis game is determined by the loser. Amateurs watch professionals play tennis and try to hit like them. They don’t have the ability to emulate their heroes, though. Their games have few long rallies, and even fewer brilliant strokes. Much more frequent is that balls are hit into the net or well outside the perimeters of the court. Double faults are common. Amateurs seldom beat their opposition; they most often beat themselves via their mistakes.

The game played by professionals is different. There are often long rallies of more than 20 shots with precise, hard hitting. Winners are frequent, whether it be service aces, groundstroke winners, drop shots and by coming into the net to volley the ball away from the opponent. Not only are there winners, but also ‘forced errors’ – where professionals force their opponent into an error through good shot making of their own. Mistakes are far fewer in the professional game than the amateur game.

Testing the theory

As a good scientist, Ramo didn’t just observe; he tested his hypothesis. Instead of counting points in the conventional tennis manner of 15-love, 15-15, etc, he counted points won versus points lost. What he found was that in professional tennis, about 80% of the points are won; in amateur tennis, about 80% of the points are lost.

In Ramo’s eyes, this proves that professional tennis is a winner’s game – the outcome of a match is primarily determined by the shots played by the winner. Whereas amateur tennis is a loser’s game – the outcome is determined by the activities of the loser. Put simply, professionals win points, while amateurs lose points.

For Ramo, this means amateur players should adopt a game style that’s most suited to winning. Forget about trying to hit a spectacular winner like the professionals. Instead, focus on making less mistakes than your opponent. Hit shots well inside the lines, don’t do double faults by trying to hit serves too hard, and hit higher over the net to allow more margin for error.

As a tennis nerd, I think Ramo’s theory rings true. And I’ve done some testing of my own.

I searched the match statistics of a recent tennis final between 19-year-old young gun, Holger Rune, and Novak Djokovic. It was a high-level match which Rune won in three, long sets. The stats show Rune hit 42 winners to Djokovic’s 36, and 20 unforced errors (easy mistakes) compared to 13. Doing the maths, Rune’s winner to mistake ratio was 68% while Djokovic’s was 73%.

This doesn’t tell the whole story as the statistics don’t include forced errors. Include these, and I’m sure that both players’ winner-to-mistake ratio would be above 80%.

Applying Ramo’s thoughts to markets

Ramo’s book has achieved some popularity primarily because of the publication of an article in an investment journal, titled ‘The Loser’s Game’, in 1975. Written by Charles Ellis, the article was subsequently turned into a book, Winning The Loser’s Game, which is now into its 8th edition.

In the book, Ellis applies Ramo’s theories to the investment world. Ellis suggests the investment game has changed from a winner’s game into a loser’s game. In the decades before 1975, the stock market was dominated by individual investors. This meant that someone who was willing to put in the work could potentially outsmart these investors and earn market-beating returns.

A big change happened in the 1960s as more professional investors started trading the stock market. By the mid-1970s, professional investors accounted for 90% of stock market activity. These investors worked 70 hours a week at their craft, and with so many of them entering the profession and with leading-edge technology at their fingertips, the stock market became more efficient and chances for outperformance largely vanished.

Winning the loser’s game

Echoing Ramo, Ellis suggests that the way you win a winner’s game is different to that of winning a loser’s game. In the stock market, as it’s become a loser’s game in Ellis’ view, there are two ways to win.

First, you can choose not to play the loser’s game. Even in 1975, Ellis had become an advocate of index investing - investing passively in the stock market rather than trying to beat it through active investing. Keep in mind that Vanguard, the behemoth of index investing, was only founded in the same year that Ellis’ original article came out.

The second way that you can choose to play the loser’s game is by losing less than your opponents via making less mistakes. Ellis advocates four ways to achieve this:

  • Be sure you are playing your own game.
  • Keep it simple. Make fewer and perhaps better investment decisions. Try to do a few things unusually well.
  • Concentrate on your defences. “In a Winner’s Game, 90 per cent of all research effort should be spent on making purchase decisions; in a Loser’s Game, most researchers should spend most of their time making sell decisions. Almost all of the really big trouble that you’re going to experience in the next year is in your portfolio right now; if you could reduce some of these really big problems, you might come out the winner in the Loser’s Game.”
  • Don’t take it personally. Most people in the investment world are trained to be ‘winners’. A failure to succeed in a loser’s game won’t be your own fault so you shouldn’t take it personally.

What it means for today’s investors

What Ellis is really trying to say is that investing nowadays is incredibly hard and you need to have an edge if you want to succeed. I think there are some prospective edges that individual investors can pursue in today’s markets:

  • Microcap investing or investing in microcap managers. For outperformance, you need to go where there’s little competition. For companies worth less than $100 million, you’ll be investing alongside other individual investors. These smaller companies are too illiquid for institutional investors, so you’ll largely remove them as competition. Do the work on microcaps, and you can have an edge.

Alternatively, you can invest in a microcaps fund. Recently, the S&P Dow Jones Indices put out figures showing Australian mid and small cap managers are among the best in the world. 40% of these managers outperform their benchmark over a five-year period, and that increases to 49% over a 15-year period. Compare that to large cap equity managers with figures of 26% and 18% respectively.

  • Adopt a long-term time horizon. Individual and institutional investors trade frequently, which increases costs and often reduces performance. Holding stocks for five years or more will give you an automatic edge.
  • Buy stocks with moats, as championed by Morningstar. Companies with moats have more durable returns and, if purchased at the right price, can led to market-beating returns.
  • Find niches. It could be becoming an activist investor in tiny companies or specializing in a burgeoning sector like community living for retirees or looking outside of stocks to something such as distressed debt, which should have a nice future with interest rates rising off historic lows.

In this week's edition ...

Jon Kalkman examines the distortions appearing in Australia's retirement system. He gives a great overview of the three pillars of the system: the age pension, super and private savings. He goes on to suggest that there are things which need urgent fixing to make the system fair and equitable.

The wealth management industry has been in the doldrums and Harry Chemay and Brett Ebedes think the key issue is the huge gap between what the customer wants to pay for advice and the cost of supplying that advice. They suggest how the financial advice sector can regain lost ground and create the foundations for future growth.

Don Stammer is back with the 41st edition of the X-factor report. Each year, Don picks the X-factor: a largely unexpected influence that wasn’t thought about when the year began but came from left field to have powerful effects on investment returns. What wins in 2022?

Vince Pezzullo from Perpetual Investment Management may have seen a preview of this year's X-factor winner because he's been busy inflation proofing his portfolio. He likes the metals sector, insurers and turnaround stocks such as A2 Milk.

The main risk to an inflationary 2023 is recession and Associate Professor Konark Saxena pegs the odds of a US recession at 75%. He thinks it will be a mild recession though, and the prospect of lower rates ahead should give Australia time to fix its main economic weakness: high household debt.

Meanwhile, it's been a year to forget for the US tech sector. Andrew Macken of Montaka hasn't lost faith though. Today he focuses on music streaming business Spotify and predicts that it could be making €6 billion pre-tax operating profit by the end of this decade, compared with a market capitaisation of €15.6 billion now. If right, it's a bargain.

And lawyer Donal Griffin runs us through a recent case where the NSW Court of Appeal reversed an earlier ruling and declared a live-in carer was in fact a defacto partner. Donal believes significant financial consequences for the family could have been avoided with preventative action.  

In the weekend update by Morningstar, Susan Dziubinski looks at the 10 best-performed US wide moat stocks in 2022, all of which are up more than 30% year-to-date. Meanwhile Katherine Lynch reports on how Vanguard has slipped to second spot beyond iShares for ETF fund flows.

This week's White Paper is from the Franklin Templeton Institute which explores the megatrend 'expanding power of the crowd', examines Web3 'tokenomic' supply, and introduces a new approach to venture capital.

***

Weekend market update

On Friday in the US, stocks caught a late bid to pare another round of substantial losses, though the S&P 500 settled lower by 1.2% to wrap up the week with a 2.8% decline after a big rally on Monday. The Treasury curve steepened a bit, as the two-year yield dropped six basis points to 4.17% while the long bond settled at 3.53%, compared to 3.48% yesterday. Gold rebounded to $1,802 per ounce, WTI crude pulled back below $75 a barrel and the VIX edged a bit below 23. 

From AAP Netdesk: The local share market fell to a four-week low on Friday on renewed fears of a global recession amid tightening monetary policy.

The benchmark S&P/ASX200 index finished Friday down 56.1 points, or 0.78%, to 7148.7, its lowest close since November 21. For the week, the index lost 64.5 points, or 0.89%, its second straight losing week after gaining five out of the past six weeks before that. The broader All Ordinaries on Friday dropped 53.8 points, or 0.73%, to 7336.5

Eight of the ASX's 11 official sectors lost ground on Friday, with property trusts flat and small gains for energy and industrials.

Utilities and tech were the worst performers, with both losing a bit more than 2%. Xero dropped 3% and Afterpay owner Block dropped 6.3%.

The heavyweight financial sector finished down 0.9%, with losses for all the big retail banks. NAB dropped 1.3% to $30.40 as chief executive Ross McEwan warned shareholders at its annual general meeting that it was "clear that 2023 will be a year of slower growth than 2022, and challenges will continue to emerge and evolve". ANZ dropped 1.2% to $23.62, Westpac fell 0.9% to $23.30, and CBA retreated 0.8% to $105.98

In healthcare, blood products giant CSL dropped 1.9% to a one-month low of $291.68.

In the mining sector, Rio Tinto climbed 0.8% to $114.55 but most of the other major miners were in the red. BHP dipped 0.6% to $45.67, Fortescue Metals fell 1.4% to $20.13, and South32 dropped 2.2% to $4.10.

From Shane Oliver, AMP: 

  • Global share markets fell back again over the last week as key central banks were more hawkish than expected which, along with weak economic data, added to recession fears. For the week, US shares fell 2.1%, Eurozone shares lost 3.2%, Japanese shares fell 1.3% and Chinese shares fell 1.1%. Bond yields fell in the US but rose in Europe and Australia. The $A fell back to around $US0.67, despite little change in the $US. 
  • While the risks remain high around inflation, interest rates, recession, the war in Ukraine and China, the Santa rally normally kicks in around mid-December on the back of festive cheer and new year optimism, the investment of any bonuses, low volumes and no capital raisings at this time of year. Over the last 15 years, the period from mid-December to year-end has seen an average gain of 0.8% in US shares with shares up in this two-week period 11 years out of 15. In Australia, over the last 15 years, the average gain over the last two weeks of December has been 1.5% with shares up 10 years out of 15. It has tended to be weaker or less reliable in years when the market is down year to date though.
  • Central banks downshift their rate hikes, but still hawkish. The past week saw a bunch of central banks raise rates again – in the US, Europe, UK, Switzerland, Norway, Taiwan and the Philippines. The good news is that the Fed, ECB and BoE slowed their hikes to 0.5% (which allows more time for lags to impact) but the bad news is that many were still very hawkish – notably the Fed and ECB.
  • With the Fed, it downshifted its rate hike from 0.75% to 0.5% taking the Fed Funds rate to 4.25-4.5% to (according to Chair Powell) “allow us to feel our way” and “better balance the risks”. But it increased its “dot plot” of Fed officials’ interest rate hikes (implying +0.75% more of rate hikes to go) on the back of upwards revisions to its inflation forecasts with Powell noting “we still have some ways to go”. The downshift in rate hikes is good news as it reduces the risk of overtightening but the Fed was still more hawkish than expected.

James Gruber

Latest updates

PDF version of Firstlinks Newsletter

IAM Credit Strategy Update - 2022 Wrap Up

ASX Listed Bond and Hybrid rate sheet from NAB/nabtrade

Indicative Listed Investment Company (LIC) NTA Report from Bell Potter

LIC (LMI) Monthly Review from Independent Investment Research

Monthly Investment Products update from ASX

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