Simple vs Complex

It’s been said that everyone has the right to have that one topic that they are utterly unreasonable about. That one subject where no matter what anyone says, they are so sure they’re right that it’s a waste of time even trying to talk them out of it.

You can’t be like that about everything, but you can be like that about one thing. A study of great businesspeople and investors confirms it – not only are you allowed to have that one subject, it turns out that you actually should.

I have mine: No one on earth will ever convince me that complexity is better than simplicity when it comes to investing. No one.

I’m a zealot about this one thing, and open-minded about everything else. It’s not as the result of an epiphany or because someone smart once told me this. I’ve earned this little bit of elemental conviction the hard way. You can’t take it from me. My grip on it actually tightens when I’m confronted with false or misleading evidence to the contrary. It glows blue like an elven sword in the presence of orcs.

As of this writing, it looks likely that SunEdison will become one of the largest financial bankruptcies in history, with a filing expected imminently. Over the last ten months, shareholders have lost 99% of their money as the stock has dropped from a June 2015 high of $31.56 to just under 25 cents per share.

Bankruptcies happen all the time, but what’s remarkable about the SunEdison situation is how many brilliant investors have been involved in the name over the last year – on both the equity and debt financing side. At Fortune Magazine, Michelle Celarier documents the hedge funds’ enthusiasm for the bizarrely structured company:

By mid-June of last year, eight months after Einhorn’s endorsement, the stock had shot up to an all-time high of $33.45, and its market cap hit $10 billion. By that time, hedge funds owned two-thirds of the shares, with shareholders including Dan Loeb’s Third Point, Leon Cooperman’s Omega Advisors, Steve Mandel’s Lone Pine Capital, and Larry Robbins’ Glenview Capital. All of those funds had sold out by September 30, 2015. The stock ended 2015 down 85% off highs, closing the year at $5.00. Still, at year-end 54 hedge funds remained in the beaten-down stock, according to Novus Research, including Steve Cohen’s Point72 Asset Management, Ken Griffin’s Citadel, George Soros’s Soros Fund Management and Izzy Englander’s Millennium Management.

I’ve remarked that the list sounds like a conference agenda. Anyone who’s anyone is on this roster. These are people with the ability to do levels of due diligence and research that are far beyond the capabilities of 99.99% of all market participants.

The exposure of these funds to SunEdison’s fallout is varied, and, in some cases, these managers ended up getting out. But the issues now plaguing the company are not new. The $8 billion debt load, the labyrinthine financial engineering model involving “YieldCo” spin-offs, the accounting questions – it was always out there. No one running real money buys into something they know is disastrous because they think they’ll get bailed out of it before the chickens come home to roost. It’s safe to say the SunEdison story fooled everyone involved, to varying degrees, for awhile.

The obvious question is How? Aren’t these the smartest investors in the game?

The answer is yes, and their innate intelligence sometimes leads them into phenomenal investment opportunities that the market doesn’t recognize as quickly. It is complexity that masks the opportunity from everyone else and offers the alpha up to those who are willing to do the deciphering and deduction.

Unfortunately, this same willingness and ability comes with an Achilles heel: a love of complexity for complexity’s sake. Sophisticated minds are often drawn to unsolvable puzzles. Organizations that pride themselves on intellectual capital can be easily tempted into overly complicated investments when a tantalizing riddle presents itself. This is doubly the case when other firms are in the hunt and the idea becomes popular among rarified circles.

This is one of the perils of attending the famed “Ideas Dinners” that are formally and informally organized among portfolio managers at top funds. A dazzling dissection of an investment idea, delivered by an articulate analyst, can become somewhat infectious. The desire to not miss the boat doesn’t go away just because a firm has already had success. If anything, it can become amplified as a winning firm grows larger and encompasses more talent to support and more mouths to feed.

The competitive instinct among top-tier firms is every bit as potent as it is among elite athletes. “I’m just as good as those other guys, they’re not going to make money without me.” This is why we repeatedly see so much “herding” among savvy investors who, deep down, probably know better.

Look no further than two of the biggest stock market calamities in recent history, Ocwen Financial and Valeant Pharmaceuticals, to see this process play out. Both were highly complex stories with layers of financial engineering and the perception that management was too smart for the room. Both served up billions in investment losses for some of the most revered fund managers of our era when it turned out that the complexity was deliberate on the part of management rather than incidental to the story.

And while piles of money are burning in the Valeants and Ocwens and SunEdisons, very quietly, the S&P 500 Low Volatility Index makes record highs. It is an index comprised of companies making cookies for a nickel and selling them for a dime. Treasury bond indexes steadily grind higher as well. Investment grade corporate bonds and US blue chips shake off recent volatility and stake out higher ground for their simplicity-oriented investors.

It should not come as any surprise that a sophisticated investment thesis will appeal to funds whose reputations are steeped in the aura of being able to solve market puzzles before the crowd. Sometimes it works beautifully but sometimes the consequences are disastrous. I’ve come to learn that, for most investors, the entire enterprise is completely unnecessary. Year after year, decade after decade, portfolios with simple building blocks and transparent mechanics get the job done. A bet that this will not be the case in the future because of (name your reason) is a low probability one.

Many intermediaries sell funds that traffic in complexity because they position it as their value-add. “There are you things you cannot understand going on in these funds, but I am managing and monitoring it for you.” It’s a barrier to entry and a justification for above-average fees. It also gives the advisor or family office person interesting things to discuss at quarterly reviews or in newsletters. It’s a signifier that the fees are being earned. Ben Carlson points to this “agency” problem as one of the main reasons so many institutions order from a menu of convoluted solutions – it’s the menu they’ve been brought by their waiter. And if something gets too simple, the intermediary can begin to feel his or her own place in the process becoming more vulnerable – what do we need you for? 

And of course, the world itself is complex, as are the investment markets. So the first notion that many investors begin with is that they need something equally complex to protect them or help them win. This is a logical fallacy, but a widely held one. I’ve come to believe that getting better as an investor is a reductive process rather than a contest to see who can add the most bells and whistles. I’ve been led down this path by evidence. The journey has forced me to let go of a lot more than I’ve been able to add.

A few years ago, my colleague Michael Batnick and I were in the midst of an immense research project in assembling one of our in-house strategies. Halfway through, I became amazed by how many variables and factors we’d been able to eliminate from our decision-making process as a result of their unreliability and inefficacy.

“None of this stuff matters? Really?” I asked him.

“Take a look for yourself, it’s pretty clear,” he showed me, across an ocean of Excel tables.

“So why doesn’t everyone do this?” I asked, thinking about all the other firms managing a similar strategy.

“I don’t know. Probably because it’s not bullshitty enough. You could never sell this to most people, too simple.”

If you opt for the simplicity path on your journey toward better investing, know that you are not alone. You are on the side of some of history’s greatest investment successes – people who’ve been able to reduce their process and strategy down to just a handful of important truths. And simple need not be conflated with easy or stupid. Albert Einstein said that “everything should be made as simple as possible, but no simpler.” Everyone can have a different place to draw the line, and still be in fidelity to the general concept.

The hard part about being in the simplicity game instead of the complexity game is all mental. At any given moment, there will always be a complex solution gaining adherents around The Street and making outsiders look as though “they just don’t get it.” Financial engineering plays like SunEdison and Valeant are only the latest examples in a constellation of intricate stories twinkling at the investor class from just beyond our grasp. Those beckoning lights in the night sky have sent generations of little boys off to bed, dreaming about being astronauts. Their pull is visceral, even into adulthood when there’s real money on the line.

***

1802: Emperor Napoleon sits in state at the Chateau de Malmaison, ready to receive the the mathematical physicist Pierre Laplace and his just completed Celestial Mechanics. In this book, Laplace has explained the formation of the solar system for the first time and has modeled exactly how the planets and stars work. For all his brutality and battlefield expedience, Napoleon is a sophisticate and an enthusiast of the arts and sciences. He is intellectually curious.

“Tell me, Monsieur Laplace, how did the solar system come about?”

“A chain of natural causes would account for the construction and preservation of the celestial system,” Laplace explains.

“But you don’t mention God or his intervention even once, as Newton did?”

“I had no need of that hypothesis.”

One hundred years earlier, Sir Isaac Newton had created a celestial model of his own. In it, he surmised that the planetary orbits were out of control and not stable, and that a God was needed to explain their course. Laplace went further than Newton, showing “it works without that, too.”