Tuesday, October 20, 2009

Found: A High Conviction Forecast

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.