Of late, for one reason or another, I’ve spent a lot of time describing Pinnacle’s investment process. For the record, the best explanation of our process is that we have a multi-faceted approach to decision making that considers fundamental or traditional valuation analysis, analysis of business and market cycles, as well as technical analysis of investor behavior. This is but another example of why we believe in diversification, although in this case it results not only in portfolios with diversified asset holdings, but a portfolio where decisions are based on more than one kind of analysis.
I’ve written previously in this space that I believe that investors who are interested in active management will first explore the technical method of tactically allocating portfolios. Using technical analysis has many benefits, perhaps the most important of which allows the advisor to develop several “rules” for following favored indicators. These rules then become a quantitative approach to decision making that is relatively simple and relatively effective. Most of the active managers that I’ve reviewed are using some type of quantitative system based on simple trend following or momentum rules – all of which are based on technical investing techniques such as relative strength, oscillators, trend lines, etc. The resulting system becomes a “proprietary decision making process,” a very valuable product to sell to investors. For the record, a proprietary process implies a secretive, valuable, exact, scientific, repeatable process that no one else can duplicate.
At Pinnacle we have also developed a proprietary investment process. It’s called “doing the work.” Unfortunately our process requires us to make qualitative as well as quantitative decisions about asset allocation. And to my knowledge, there is no easy way to make a decision based on the weight of the evidence as determined by our judgment, experience, and expertise. For us it means slogging through the 100-plus economic releases each month to find clues regarding the market cycle, Fed policy, currency direction, etc. It also means reading daily, weekly, and monthly research reports from dozens of brilliant analysts who disagree with each other all of the time. Marrying this process with our own proprietary quantitative approach is nothing but hard work. But it sounds a lot better when we call it our proprietary investment process. For the record, our proprietary process is inexact and messy, but I have a great deal of confidence that it is the lowest risk method for making investment decisions.
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Task number two this weekend was to catch up on my investment research, a seemingly endless proposition that punishes my weekly tendency to procrastinate in my reading. Task number one was to write a marketing brochure for Pinnacle to use in a potential new venture. I have written our story so many times that it’s difficult to get overly enthusiastic about doing it again, but I am the Chief Investment Officer and explaining what we do is a big part of the job. An important part of our story is our belief that relative value investing makes sense. For us, relative value essentially means that we will vary our portfolio construction based on our conviction in our investment forecast. We measure our success in earning excess returns for our clients by comparing our results to a portfolio with a fixed asset allocation. The special name for this hypothetical portfolio is our benchmark, and if we are successful in identifying good investment values we will earn excess returns relative to our benchmark.
While pondering (once again) how to explain the intersection of benchmarks, value investing, tactical asset allocation, and high conviction forecasts, I decided to take a break and read a research piece from Lombard Street Research called, Deflation to hit Germany and America. Charles Dumas is the well respected analyst who penned this somewhat technical and very detailed piece on his views regarding the outlook for deflation in the U.S. and Germany. While I shouldn’t have been rewarded for deviating from task number one to dally in task number two, I couldn’t help but be struck by the certainty in Dumas’s forecast. In fact, the Pinnacle investment team reads hours and hours of research, and I can safely say that Dumas went way out on the limb of high conviction writing. Here are a few examples:
“For the time being, with stock and house prices down some 30-40% from their peaks, people worrying about booming asset prices causing inflation have to be seriously detached from reality.” Or, “In these conditions, financial collapse centered on the dollar is verging on the impossible.” And my personal favorite, “To talk of inflation resulting from this is plain stupid.” I say bravo to Mr. Dumas. We highly value analysts who advance clear points of view and back them with sound analysis. This is not to say that I personally agree with Lombard’s deflationary case for the world, which is by the way, rather gloomy reading. However, it is a good reminder of how our investment process works. When we occasionally have the same level of conviction as Mr. Dumas, Pinnacle clients can expect larger rather smaller deviations from our benchmark portfolio. And if our forecast is correct, it is from these conditions that we would typically generate the most excess returns for our clients.
Sometimes I pine for the good old days at Pinnacle when the prime ingredient for measuring investor success was patience. Back in the day when we were strategic buy and hold investors, the returns of the asset classes that we owned in our portfolio were assumed to be a given, as long as we waited long enough for them to appear. Since the underlying theory suggested that markets were always efficiently priced, and since our clients agreed that returns could and should only be measured over the “long-term,” we could asset allocate our portfolios based on past returns. With the backing of the financial media and virtually all of our industry pundits and thought leaders, everyone involved agreed that patience was the key to success.
Times have certainly changed for the Pinnacle investment team (Truth be told, in the old days we didn’t have a Pinnacle investment team because there wasn’t a need for one!). Today we actively manage portfolios to take advantage of changes in asset class valuations, changes in the market cycle, and changes in market internals such as investor sentiment. The challenge of this strategy is that in today’s markets the data comes fast and furious and the financial markets can be influenced by the news in unforeseen and unpredictable ways. The inevitable result of such fluid market conditions is that the holding period for securities in the portfolio continues to shrink. Where we used to hope to hold equity positions for periods of years, we now would be happily surprised if that were the case. The market rally since March 9th is a good case in point. As the markets have violently rotated from defensives to early cyclicals to late cyclicals, investors who were not nimble enough to follow the cycle missed out on excellent opportunities for excess returns.
Last week, our portfolio manager for our Dynamic Ultra Appreciation portfolios, Rick Vollaro, put on a trade to possibly take advantage of what we perceive to be the short-term overbought condition of the market. He sold a position in an exchange trade fund that owns the Materials sector and bought a 2x inverse position in the same sector, effectively reducing our equity exposure in that portfolio by 10%. He intends to take the trade off as soon as we get the correction that he is anticipating. The good news for me is that Pinnacle has the expertise and the technology in order to execute such an innovative transaction with ease. However, I can’t help but smile at the gigantic changes that have occurred in our portfolio management philosophy over the past 7 years. We wouldn’t have considered this trade, even in our most aggressive portfolios, as little as two years ago. Today we consider these kinds of transactions to be a reasonable and necessary part of our risk management process and an integral ingredient in our quest for excess returns in difficult markets. We’ve come a very long way from patience being the primary strategy we rely on to earn expected returns for our clients.
Financial Planning | Ken | 
October 30, 2009 1:42 pm | 
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