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Nonlinear Thinking: The Secret to Long-term Active Investing

2011 May 25

Long-Term, Non-Linear Investing

(Unpublished, unfinished short essay, by Jarrod Wilcox, written in 1996 for private use.  Fifteen years later, it is clear that though some of the bets would not have worked, the overall batting average is surprisingly good.  Today’s focus would of course be different.  But the overall approach would be similar in any context.)

Active investors try to earn superior returns by investing differently from other market participants through one of several approaches.  We can look at the same data and react to them the same way but more quickly, as when we immediately buy because of revisions in IBES consensus earnings estimates.  Alternatively, we can try to make different decisions by reacting to the same data using the same concepts, but in a contrarian direction.  This is what we do when we sell on good news.

However, there is yet a third and more radical alternative.  We can try to avoid the decision inputs and concepts used by most market participants.  This is easier said than done, because as social beings we get almost all of our ideas from others.  However, we can harness three systematic approaches to step outside the market’s dominant conceptual framework.

One way to step outside is to think of longer term causal forces.  That is, there is a distribution of time horizons in the discourse and thinking of market participants, and we can consciously attempt to get out on the long-term tail of that distribution.  For example, impressive returns were experienced by the pioneers who invested in emerging markets before their superior growth became well established in the market’s collective awareness.

A second way to step outside the market’s thinking is to avoid linear extrapolation of current trends. Superior profits ought to come from successful forecasts when there are no obvious clues in the immediate neighborhood of the usual influences on the event in question.

A third way to step outside is to seek ideas from sources out of the mainstream of the financial press and conference circuit.  Ideas spread like viruses.  You are more likely to catch a fresh one by visiting a new community.

The working hypothesis of this essay is that the chances of arriving at profitable investment ideas can be enhanced by the method of seeking long-term ideas from outside the usual sources of investors and sorting through these ideas for those that are most non-linear and thus most likely to surprise other market participants.

Sample Source of Outside Ideas

For the purpose of this essay, we will use ideas from a book by a historian, Paul Kennedy, Preparing for the Twenty First Century, published in 1994, as the stimulus for thinking about a particular set of long-term processes that may plausibly shape global economic results over the next several decades.  Mr. Kennedy, as a readable historian who takes the long view, is as far as I can determine, very little discussed in financial circles.  However, his book is now several years old, and similar ideas are beginning to show up in places such as op ed articles in the Financial Times.  In actual investment work, one would seek to make use of newer or more iconoclastic sources.

Kennedy’s Issues

  • Population growth problem:  external aggression, social unrest, acceleration of environmental damage, pressures for aid and emigration, growing social inequity, growth of less developed country population.
  • Rise and fall of individual nations: US, Europe, Japan and China compete for influence. Country on top reluctant to change.
  • Technology: robotics, biotech, communication — increased knowledge by its very nature may cause inequality, how do we share the wealth without slowing down introduction of new tech, worries rich will put poor people out of work.
  • Demographic shifts: In developed countries, as population growth rates slow down, many more old people.  In less-developed countries, youth promotes crime and war
  • AIDS: as a wild card heavy user of net resources because preys on working age people
  • Environment: environmental damage, global warming, greens versus economists
  • Migration: flood of economic refugees from poor countries, though biggest flow may be from middle countries with worker skills. Middle class in developed countries face new competition.

A Set of Tools

The next step in screening long-term ideas from unusual sources is to pick out those that are non-linear, or can lead us to a related non-linear concept. First we need a set of conceptual tools.  I exclude as too nearly linear the process of exponential growth at a steady percentage rate.  Here are four types of non-linearities which the market is more likely to miss, especially if they occur over long time periods, together with examples.

1. Very Long Cycles:

The future course of a pendulum can be hard to predict if it is sufficiently slow relative to the observer, particularly if there are some shorter term irregularities in its motion.  In the recent past, for example, first the boom in Japanese equity and real estate values contributed mightily to a subsequent equity and real estate price collapse, and then that collapse led to weak banking and long-term investor avoidance.  Eventually, there will be multiple years of sharp recovery. In each such case, a predominant trend over a multiple year period creates a large reversal opportunity.  This kind of overshoot cycle is the mechanism behind industry capacity cycles as well, such as we have seen in the oil business. A hardy band of investors believes in a 50-60 year Kondratief economic cycle. The U.S. has been on top for a long time, and this kind of thinking would lead to watching for a good opportunity to increase investment allocation to Japan and to up and coming emerging market economies when they are cheap.

2. Worse-before-better

Some very interesting opportunities have developed where the non-linearity involves a change in direction that cannot be anticipated using “normal” cyclical thinking involving excess or overshoot, but instead what might be called “worse before better.”  This happens whenever long-term improvement can only be obtained at the expense of current production.  It can be seen in product development cycles in technical companies.  On a larger scale, a country such as Chile that takes tough monetary action to reduce super inflation may cause a recession in the short term but higher rates of growth in the longer term.  Of course, there is also a better-before-worse phenomenon when long-term investment efforts cease, resulting in a temporary increase in production.

3. Sudden Cessation or Acceleration of Change

Surprises don’t always reverse an existing trend; sometimes the previously linear trend suddenly accelerates as a critical mass is reached or a barrier is overcome.  The vivid examples of South Korea, Taiwan, Singapore and Hong Kong appear to have contributed to the fall of Communism. The latter accelerated the process of conversion of centralized governmental economies to free enterprise, making investment in emerging markets suddenly much more attractive to developed country savers.

4. Secondary Surprises

Finally, some changes may in themselves be somewhat predictable, but they are so large and novel that they lead to many secondary surprises along different dimensions over a longer period of time.  For example, the fall of the Berlin Wall has led to more intense competition within the world steel market as former Communist countries experience their greatest initial trade success in commodities.  As another example, space satellite communications led to fragmentation of  the distribution of television programming, and in turn to specialized news networks such as CNN, itself a further change agent.

Screening Kennedy’s Ideas

The following is a straightforward implementation of the suggested method. Each idea is a starting point for investigation, which may be supported by lack of investor interest and discussion, and lead to an investment theme.

I can not see obvious opportunities to think differently from the market with respect to Kennedy’s ideas with respect to the Environment and AIDS.

There is already huge market interest in Technology, but perhaps less attention to the resulting secondary consequence of growing income inequality’s investment consequences.  This would argue in favor of the growth of low-cost goods and services for the large fraction of the population who do not enjoy much benefit from new technology.  They may even be worse off because of increased competition from migrants and globalization.  Buy do-it-yourself repairs, discount retailing, fast-food.  There may also be opportunities for very high-end luxury goods

Population growth argues for increased international tensions as exponential growth runs into barriers — buy defense industries.  Investigate local energy sources.

Migration to the U.S. will accelerate.  Buy ethnic support companies — imported food, foreign language entertainment and publications.

Demographics suggest increased services for older population.  Buy financial service companies.

China is over-watched.  But the Rise and Fall of Countries also favors the rise of former European and Soviet Communist economies, which should gradually accelerate.  Establish a position while they are still cheap.