Dear Reader,

The folks at Morgan Creek Capital Management were kind enough to allow me to share with you an excerpt of their quarterly review and outlook, authored by prolific CEO Mark Yusko. Some of you will recognize Mark from our last Casey Research Summit; attendees loved his insightful and passionate presentation on where in the world the best investment opportunities are today. If you’re not familiar with Mark, he was the head of the University of North Carolina’s endowment before founding Morgan Creek.

In what follows, Mark discusses the most important lessons he’s learned from legendary investor George Soros. Its a tour de force in investment theory. At the end of the excerpt, you’ll find a link to the full Q4 report. I encourage you to read the whole thing, especially Mark’s “Ten Surprises” for 2015.


Dan Steinhart
Managing Editor of The Casey Report

Reflexivity: The Virtuous & the Vicious

By Mark Yusko, Founder, CEO, and CIO, Morgan Creek Capital Management

Due to a coincidence of the calendar, I write my Q4 letter each year during Super Bowl week and the hype surrounding the event has provided inspiration in prior years for the letter’s theme. This year, we take a break from the football analogies to talk about an MVP-worthy performer in the investment business that has provided many pearls of wisdom (and a little philosophy) over the years that we can apply to the current investment environment.

George Soros is widely regarded as one of the preeminent investors of our time after compiling a track record over four decades from 1969 to 2009. That is, without question, Hall of Fame material. Given that there are simply not that many investors who have track records of this duration, it is tough to make direct comparisons at all, and making comparisons across decades is tough because of the very different economic and market environments that exist from decade to decade.

But there is one investor who was in the market the entire time as Soros and actually has a track record that we can stack up side by side to gain some perspective. Warren Buffet closed his private partnership (BPL) to new capital in 1966 and, by 1969, had transitioned to running as a closed-end fund named Berkshire Hathaway.

For the 41 years from 1969 to 2009, we have good data on Soros vs. Berkshire (thanks to Veryan Allen at @hedgefund who collected the information and calculated the returns) and the results are nothing short of astonishing. Warren compounded wealth over that period at a stunning 21.4% (more than double the S&P 500 return over the period) and would have turned a $10,000 investment into $28.4 million. But Soros did better, compounding at 26.3%. That doesn’t sound like that big a difference, but through the miracle of long-term compounding, that $10,000 original investment would be worth an extraordinary $143.7 million.

Forty-one years is a long time to stick to one strategy and clearly very few investors benefitted completely from any of these three track records. The numbers assume that you reinvest all the dividends, never take any distributions, and invested at the beginning and stayed invested until the end. But that’s tough.

As famous stock operator Jesse Livermore once said, “It was never my thinking that made the big money for me, it was always my sitting.” Understanding full well that most investors only earn a fraction of what is available in any investment strategy, simple math says that a fraction of George or Warren’s performance is far superior to a fraction of the S&P 500 performance.

With that, I have compiled a collection of “Sorosisms” from various sources over the years and have tweeted many of them individually to provide insight on a particular event or opportunity in the market, but for this letter I have selected my favorite (many from a great compendium of 50 of George’s best at to discuss the Soros philosophy of Reflexivity and make the case for why it is so important for investors to understand, particularly today.

Thinking Like George

The core of Soros’ thinking on investing stems from the idea that there is a two-way interaction between the Cognitive (how we understand the environment in which we interact) and the Manipulative (how we change the environment in which we interact). In essence, he postulated that the actions we take are influenced by how we perceive the environment, which is skewed by our biases or lack of information. Our actions then impact the environment, which change our subsequent view of the environment in an endless feedback loop. The notion of evolution would lead to continuous, self-reinforcing cycles (both virtuous and vicious) that he reasoned could explain the boom/bust cycles observed in financial markets.

This principle of Reflexivity is based on the construct that markets tend toward disequilibrium, rather than equilibrium, because the actions of the participants are exaggerated by their biases, or misconceptions, about the market itself and their subsequent actions then change the valuation of those markets which further reinforces those biases in a self-reinforcing feedback loop.

Soros does not mince words when he says: “The concept of a general equilibrium has no relevance to the real world (in other words, classical economics is an exercise in futility).” Given his track record of generating excess returns, it is hard to refute his logic. In reflecting on this point, one hypothesis could be that the core philosophy an investor adopts could (in a Reflexive manner) actually increase the likelihood that they achieve excess returns over time. Similar to how an outstanding golfer increases the odds of hitting consistently good drives by visualizing hitting down the middle of the fairway in advance, while the duffer consistently slices into the woods by worrying about slicing into the woods as they address the ball. If we believe that we will earn excess returns by understanding the cyclical nature of markets and their reflexive response to participants’ collective actions, perhaps we can exploit those opportunities more effectively rather than be exploited by them.

Price Is a Liar

When John Burbank of Passport Capital spoke at our iCIO event, the title of his speech was “Price is a Liar,” a concept that Soros expounds upon when he says, “the generally accepted view is that markets are always right, that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite view. I believe the market prices are always wrong in the sense that they present a biased view of the future.” The construct here is that in a Reflexive world, where markets tend not toward equilibrium but toward disequilibrium, the current price of a security is not a reflection of “fair value” as the Efficient Markets Hypothesis would have us believe, but rather a temporary “unfair value” driven by the virtuous, or vicious, cycles created by market participants’ misperceptions and the resulting collective inappropriate actions that come from participants acting on those misperceptions.

A perfect example of this phenomenon could be seen at the peak of the equity market in March of 2000 when investors had a collective misperception of the value of technology companies like Microsoft and Cisco (and many other even more outrageously valued names.) Just for some perspective on why price is clearly a liar, it would take Soros nearly 25 years to compound $1 into $286, Buffet would need 29 years, and if we had to wait for the average return in the S&P 500, it would take almost 60 years. Soros was right (as usual) and the CSCO market price was wrong, the tech bubble crashed, investors like Soros cleaned up being short those companies, and today, 15 years later, CSCO stock is still down 65% from that peak valuation. To show Reflexivity in action, not one of the 37 Wall Street analysts at the time had Cisco rated anything lower than a “Buy” or “Strong Buy” (not a “Hold” or “Sell” anywhere to be seen) at the precise peak in the stock, a stock that would then essentially decline nearly in a straight line for the next decade and a half.

Soros speaks specifically about the challenge of misperceptions when he says, “being aware of Reflexivity, genuinely, I am often overwhelmed by the uncertainties. I’m constantly on watch, being aware of my own misconceptions, being aware that I’m acting on misconceptions and constantly looking to correct them. Misconceptions play a prominent role in my view of the world.” The reality is that we will never have complete information.

So as human beings continually act on their misconceptions, Reflexivity says that those actions then begin to distort the financial markets themselves, which actually impact the actual fundamentals of the markets themselves. Soros says “I contend that financial markets never reflect the underlying reality accurately; they always distort it in some way or another and the distortions find expression in market prices. Those distortions can, occasionally, find ways to affect the fundamentals that market prices are supposed to reflect.” Again we can look to the technology bubbles (2000 and again in 2014) to see how this reflexive pattern works. As the prices of stocks in the technology sector run up, investor perceptions of the potential impact of those technologies (and companies) begins to grow in an exponential fashion. As the mania spreads, more money is attracted to the industry and the price of stocks rises at a rising rate.

Soros has described how this virtuous cycle can lead to market bubbles, driven by Reflexivity: “Stock market bubbles don’t grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception. Every bubble consists of a trend that can be observed in the real world and a misconception relating to that trend. The two elements interact with each other in a reflexive manner.”

One of the most direct reflections of Reflexivity in the markets that Soros found in his work was the relationship between credit and collateral. He said, “I made two major discoveries in the course of writing: one is a reflexive connection between credit and collateral, the act of lending can change the value of the collateral, the other is a reflexive relationship between regulators and the economies they regulate.” The housing bubble that was created in the US in the mid-2000s was a case study in how the expansion of credit (Dr. Greenspan encouraging everyone to get bigger mortgages) can reflexively change the value to the collateral being lent against. Housing prices surged ever higher as greater credit availability increased the demand for homes by bringing a greater number of buyers into the market. Only later did it dawn on investors that the incremental buyers were called “Sub-Prime” for a reason and they were not as likely to repay those loans as the Prime borrowers had been historically. Once again, the participants in the market had their reality (prices should rise as demand surges) altered by a misconception that all homebuyers were of equal quality and durability.

Soros goes on to say that “money values do not simply mirror the state of affairs in the real world; valuation is a positive act that makes an impact on the course of events. Monetary and real phenomena are connected in a reflexive fashion; that is, they influence each other mutually. The reflexive relationship manifests itself most clearly in the use and abuse of credit. It is credit that matters, not money (in other words, monetarism is a false ideology).” As the valuation of homes continued to rise, there was a reflexive response by borrowers to reach for larger homes (prices could only go up, so more opportunity to make huge profits), which further increased the demand for credit. As banks could no longer retain that much risk on their balance sheets, they found ways to securitize the loans and distribute the risk to other market participants. This provision of new securities created another reflexive response in the creation of leveraged pools of these “safe” securities (or so the models said they were safe) and that allowed the banks to further expand their lending activities. Then the second part of the Soros discovery came into play as the Regulators reflexively relaxed the rules for the creation, distribution, and valuation of these securities, leading to increased demand, and the virtuous cycle was set into overdrive. Banks could hold unlimited amounts of these securities in the absence of mark-to-market risk and another Soros quote applies here that “whenever there is a conflict between universal principles and self-interest, self-interest is likely to prevail.” The universal principle that there should be a relationship between risk of loss and provision of new loans was overridden by the self-interest of originating as many loans as possible to generate high fees, knowing that the risk could be sold to other investors through securitization (creating more fees and more self-interest).

In the mad scramble for loan creation during the final phase of the Housing Bubble, the government created an environment of essentially free money by allowing the big agencies, Fannie Mae and Freddie Mac (or Phony and Fraudie, as I often affectionately refer to them), to securitize loans to the bottom of the barrel risks with crazy terms like no money down and incredibly low “teaser” interest rates. Soros has a comment that applies here as well: “when interest rates are low we have conditions for asset bubbles to develop. When money is free, the rational lender will keep on lending until there is no one else to lend to.” That is exactly what happened, the lenders exhausted the pool of borrowers, the reflexive impact of rising demand pushing prices higher began to wane, and the virtuous cycle turned dramatically (as they always do eventually) into a vicious cycle that triggered the Global Financial Crisis and those same banks that made all the ill-advised loans were crushed by massive losses Then, yet again, what were the “Masses” doing at the peak? Why, of course, they were loading up on index funds, that were loading up on what had run the most (in classic reflexive fashion), the banks and financials; so when Citi and BofA fell (95%) and Phony and Fraudie fell (99%), investors learned, yet again, that price is a liar.

What to Do? Admit Your Mistakes

Reflexivity is rooted in uncertainty, and it is that uncertainty which leads to the dramatic misconceptions of market participants who push markets to extremes, resulting in the booms and busts we have all experienced over the years. Soros has an important belief related to this construct, that “the financial markets generally are unpredictable. So that one has to have different scenarios… The idea that you can actually predict what’s going to happen contradicts my way of looking at the market.” They say risk defined more things that CAN happen than WILL happen and he contended that the idea that anyone could consistently pick out which of the myriad outcomes is likely in the financial markets over time was folly.

Despite the challenge of divining the future, his investment strategy was not to do nothing (for fear of being wrong). On the contrary, he would acknowledge the uncertainty, as well as his own biases and misconceptions, and boldly make decisions and investments. He states very clearly, “you have got to make decisions even though you know you may be wrong. You can’t avoid being wrong, but by being aware of the uncertainties, you’re more likely to correct your mistakes than the traditional investor.” He then goes on to explain why it is so hard for most investors to admit when they are wrong, to accept that they have made an error, and to correct the error before it grows into a more costly mistake. I have been fortunate to interact with many of the very best investors in the world, to talk about their investment strategies, and all of them talk about the ability to limit the losses when you make a mistake. Soros, as always, thinks about the concept with a philosophical perspective: “once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes.”

Making mistakes as an investor is inevitable, but failing to correct your mistakes is inexcusable and can, in the worst circumstances, be cataclysmic to your wealth. Soros has also stated very clearly why this concept is perhaps the most important concept in investing in saying “I’m only rich because I know when I’m wrong. I basically have survived by recognizing my mistakes. I very often used to get backaches due to the fact that I was wrong. Whenever you are wrong you have to fight or take flight. When I made the decision, the backache went away.”

Being wrong means you are losing money. Losing money means you are eroding the power of compounding, and given George’s amazing long-term track record of compounding, he clearly never stayed in pain very long. You can’t compound at 26.3% (for any period, let alone 41 years) if you don’t recognize your mistakes and take swift and decisive action to correct your errors. Peter Lynch was famous for saying that the best way to make money was to “let your flowers grow and pull your weeds” (another way of saying fix your mistakes). The problem is that most investors do the opposite, they pull their flowers at the first sign of making a profit and they let their weeds grow because they are too proud to admit they are wrong or too stubborn in wanting to show the world that they are right.

The Soros Style

In describing his firm, Soros said, “we try to catch new trends early and in later stages we try to catch trend reversals. Therefore, we tend to stabilize rather than destabilize the market. We are not doing this as a public service. It is our style of making money.” It’s very clear that his goal is to extract economic rents (make money) by capitalizing on the collective errors of the broad market participants following the boom/bust cycles. These participants constantly buy what they wish they had bought and sell what they are about to need (like those investors selling hedge funds today to chase the hot returns that index funds achieved over the past five years). One of my personal favorite Soros quotes is that “it does not follow that one should always go against the prevailing trend. On the contrary, most of the time the trend prevails; only occasionally are the errors corrected. Most of the time we are punished if we go against the trend. Only at an inflection point are we rewarded.” So often people incorrectly label great investors as contrarians, or vultures, and think they simply lay in wait for some big dislocation and pounce, but Soros says that the bulk of the returns come from patiently sitting (the Jesse Livermore word again) and riding the trends toward the extremes that are created by the reflexive process in the markets. Most investors miss the majority of the gains available in a trend because they doubt the persistence of Reflexivity and the relative infrequency with which the collective errors are corrected.

Now, precisely because the trends will go to extremes, it is critical to be on the lookout for the inflection points and be ready to reverse your position. Soros describes it this way: this line of reasoning leads me to look for the flaw in every investment thesis. I am ahead of the curve. I watch out for telltale signs that a trend may be exhausted. Then I disengage from the herd and look for a different investment thesis.” The continual “Devil’s Advocate” approach maintains a discipline to not fall in love with your own idea or analysis and let the market tell you when it is time to modify your hypothesis.

Soros describes one of the ways to tell when a trend is exhausted as “short term volatility is greatest at turning points and diminishes as a trend becomes established. By the time all the participants have adjusted, the rules of the game will change again.” Volatility is generated when investors without conviction cannot hold their position as the trend begins to change. The early adopters of a trend are the most knowledgeable and have the greatest time horizon, so they are able to hold through the normal ups and downs that occur in the markets. As the trend matures, the latecomers, who are simply chasing the past performance, have little conviction in the trend and can be easily shaken out when the original investors begin to take profits and move on. That high level of volatility is indeed a telltale sign of turning points (both up and down) in the investment markets. One of the biggest reasons for that is that the bulk of the investment capital is controlled by large institutions and Soros describes the problem very well in saying “the trouble with institutional investors is that their performance is usually measured relative to their peer group and not by an absolute yardstick. This makes them trend followers by definition.” That trend following behavior exacerbates the reflexive process and leads to higher highs and lower lows, resulting in lower overall returns for the average investor and institutions as a group, but also leads to truly outstanding returns for investors like Soros who understand Reflexivity and have the discipline to take the other side of these short-term investors’ movements.

The Final Lesson

The final lesson from Soros is quite similar to the lesson we wrote about a couple quarters ago in #NotDifferentThisTime on the wisdom of Sir John Templeton who said that investors would always ask him where is the best place to invest, and he would respond to them that this was exactly the wrong question and that they should rather be asking where is it the most miserable? Investing where things are good and comfortable will consistently yield mediocre returns; not bad returns, just not great returns. I have often said that if you make an investment and you feel OK, you will make OK returns; if you feel good, you will likely lose money; and if you felt a little queasy, you will likely make money.

Soros says it a little bit differently in that “the worse a situation becomes, the less it takes to turn it around, and the bigger the upside.” His view is perfectly aligned with Sir John, or with Arjun Divecha at GMO who says “you make the most money when things go from truly awful to merely bad.” Soros’ point is that once things get really bad and the reflexive process has driven the trend to the extreme, the slightest change in perception can turn the tide and the bigger the move will be on the other side. George does add a couple qualifiers here in saying that “unfortunately, the more complex the system, the greater the room for error. The hardest thing to judge is what level of risk is safe.” The markets are huge complex adaptive systems (that tend toward extremes of disequilibrium thanks to Reflexivity) and the complexity has been rising at an ever-increasing pace with globalization, financialization, securitization, Central Bank intervention, and the increase in speed of everything from information dissemination to trading. Higher complexity means greater risk of errors and higher costs for those errors; so the most challenging thing to determine, according to Soros, is what level of risk is appropriate for investors to take. What these final thoughts seem to say quite loudly is that in an increasingly complex investment world, risk management and mitigation are paramount, that the ability to admit when you are wrong on a position and exit with a small loss is critical, that the necessity to maintain focus in areas of strength and expertise and not stray into unfamiliar territory is crucial, and that understanding how the construct of Reflexivity can help us structure positions more effectively to capitalize on investment trends and take advantage of market dislocations. We believe that heeding the lessons highlighted above can help all of us spend more time enjoying the virtuous and less time being punished by the vicious.

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