Welcome to Idle Speculations. This blog is written by a Manhattan resident who has spent the better part of a decade working in the leveraged finance and special situations investing business. I’ve been hired by several incredibly smart, motivated people at the top of the profession over the course of my career, and I’ve tried to absorb learnings from all of them along the way.
The process of investing capital holds great intellectual appeal for me. Investing represents a game with multiple levels, and to do it well seems to require all of the major life skills. At the surface level, the game is simple: an asset is available at a price, and in a free market, the choice is whether to buy or sell the asset at that price. The intellectual appeal of the game runs much deeper than that. What makes it interesting?
- Which market? In a large, globally connected world, markets have developed for nearly everything – Joe Sixpack’s Fidelity app gives him access to the market for Tesla shares, the Travelex booths at JFK make markets for foreign currencies, classified ads in newspapers facilitate markets in used cars, Christie’s and Sotheby’s facilitate price discovery in Old Masters paintings, and traders at One West Street (the headquarters office of Goldman Sachs) make markets in United States Treasury bonds. How does an investor of capital decide which markets to survey for opportunities? Answering this correctly requires a calibration of the time horizon of the capital, the liquidity expectations of the capital, the expertise of the person deploying the capital, the amount of capital to be deployed, among other factors.
- What drives the price of an asset? Markets will fluctuate, said some wise man. Two things drive assets. In the near- and intermediate-term, the price of an asset is determined by supply and demand – put simply, an excess of buyers drives prices higher, while an excess of sellers drives prices lower. In the intermediate- and long-term, asset prices must be driven by their “intrinsic value”, or the present value of the cash flows generated by the asset. This answer simplifies things, and why that is the case is the subject of a future post.
- What drives supply and demand of an asset? Financial markets serve two functions, primary and secondary.
- Primary financial markets activity occurs when end users of capital raise funds from savers with surplus funds. This occurs when the U.S. Treasury issues bonds to finance cash shortfalls, when students borrow to finance a college education, when Tesla deludes investors into buying into yet another issuance of stock, etc. The market price of capital drive the demand for capital (the converse of the supply of primary assets in the financial markets) – students will borrow more for their degrees when interest rates are low.
- Secondary financial markets activity occurs when savers who have invested funds seek to reallocate their capital or liquidate assets to generate cash spent on real-life needs – in the first case, think investors reallocating stock portfolios into a biotechnology company following news of a positive FDA trial result, in the latter case, thing retirees liquidating 401(k) assets to fund their Del Boca Vista Homeowners’ Association dues. In other words, supply and demand can come from structural factors (structural saving or dissaving, often driven by demographic trends or sovereign / central bank activities), or from shifts in perceptions about the prospects of future returns.
- What drives intrinsic value of an asset? It has long been accepted that the value of an asset is equal to the present value of the expected future cash flows to be generated by that asset. There are two components to this analysis:
- The investor of capital can develop an “edge” by better understanding the prospects for future cash flow generation. The perceptive capital allocator who could discern that Amazon was going to eat Border’s lunch ahead of others could capitalize on that knowledge.
- For a given set of expected future cash flows, the present value is driven by two factors. Since investors can invest to term “risk free” (more on those “quotation marks” at a future date) by investing in government securities, the rate on Treasuries is the bogey against which other return opportunities are measured – if U.S. Treasury securities offer a return 0.25% higher next week, assets will need to reprice to reflect that alternative. Additionally, since cash flows are expected and not risk-free, investors need incremental return above the risk-free rate offered by Treasuries. How is that incremental rate determined? By the market’s perception of the risk of those expected cash flows, which is ultimately driven by general economic volatility and structural changes in an industry.
- Is that is? Definitely not. The framework just described is a fine set of principles, but leaves out incredibly interesting and potentially profitable nuance and complexity. The most interesting complexity in capital allocation derives from non-linearity. Think back to our intrinsic value formula above: the value of an asset is equal to the present value of expected future cash flows. Now imagine you own drilling rights over oil in the Bakken. WTI crude currently trades at $43 per barrel, but you can’t make money drilling your land unless oil is above $50 per barrel. Does that mean your expected cash flows are $0, and as a result your asset isn’t worth anything? Not even close! What you own is, in rough parlance, a “call option” on oil struck at $50. If/when oil rises above that $50 level, you are in-the-money, and can drill profitably. You know intuitively that just because oil is trading at $43 today doesn’t mean it won’t trade at $50 in six months. Much more to discuss on this front, but for now, suffice it to say that option value is a commonly misunderstood concept in the business of capital allocation – we are trained to think too linearly.
That starts to scratch the surface of why I find the business of allocating capital, or speculating, a compelling way to spend most of my waking hours. The word “speculation” typically carries a negative connotation, which deserves to be dispelled. The Latin origin, specio, means “look”. The Roman army’s speculatores were scouts, and speculatio was what they did. So, to speculate entails observation. The current dictionary definition, says that speculation, in a commercial context, entails taking “outsized” business risk in the expectation of commensurate reward. So, to speculate should involve first, observation and evaluation (scouting), and using the knowledge gained to take risk in the expectation of reward. We can argue later about what is an outsized risk and what level of reward is commensurate, but for now I’m going to stipulate that to speculate is to be a good capitalist – one observes, hypothesizes, evaluates, gets set, and bets. I find that going through life with the mindset of speculation prompts constant engagement, critical thinking, questioning of conventional wisdom, probing of first principals, and enables one to put Skin in the Game (apologies to Nassim Taleb for any trademark infringement). It’s a life of constant interest and novelty. This site will serve as an outlet for some of my intellectual speculations, and I hope it will prompt exchange with others with informed view.
Thanks for stopping by. More to come soon.