Trust the Process

It has been a while since I wanted to re-read and comment on Sam Hinkie’s resignation letter. Sam was the Philadelphia 76ers (an NBA team) GM and left in 2016. At the time, he took on a crappy team and tried to make it better by…making it even crappier. At least in the short term. This is due to peculiar rules common in US professional sports: being closed leagues (no promotions or relegations), to keep the show more interesting every year the worst team can call dibs on the new joiners. Sam was trying to game the rules: by being intentionally bad, he could aim to acquire (hopefully) great future players for ‘free’ and grow a winning team from there. If you are still clueless, google what the NBA draft is.

It turned out that the patience of the fans and the team owners was shorter than his plan required, and he got fired resigned.

The letter was never meant to go public. Despite Sam’s quite peculiar role, its content can be related to many fields, including investing. Actually, at the time many thought he was writing more as a Portfolio Manager than a sport executive.

I read many takes about it when it came out; most were against him. I was not following the NBA as much as I do now, you can imagine how much I knew about a team that was winning a game as often as Nuriel Roubini was making a correct call about markets. I was not yet in love with Daryl Morey, therefore I didn’t have a clue about his pupils.

Years later the Process, as Sam’s plan was commonly referred to, proved at least something. It is hard to judge because the folks who took the helm after Sam left did a strategic u-turn (meaning they used and spent all the resources accumulated by Sam) but In 2019, 3 years after Sam’s departure, the 76ers lost to the Raptors in a Game 7 at the last second; the Raptors would move to win it all. The NBA in the meantime, changed the rules around tanking (losing on purpose to acquire draft talent): for the right or wrong reasons, other GMs followed Sam’s steps.

Matt Levine wrote a piece that made me discover the whole story. Too bad it is impossible to find it, damn Bloomberg. It would be great to re-read that as well.

I copied relevant excepts followed by my comments.

A competitive league like the NBA necessitates a zig while our competitors comfortably zag. We often chose not to defend ourselves against much of the criticism, largely in an effort to stay true to the ideal of having the longest view in the room.

It is critical to be cycle aware in a talent-driven league.

More practically, to take the long view has an unintuitive advantage built in—fewer competitors.

One of Sam’s pillars is to hold “the longest view in the room”, meaning to pursue what is beneficial in the long term instead of chasing short-term manias. As already said by many before me, this is probably the only advantage DIY investors have compared to professionals. Multi-pod hedge funds have a 3-month tolerance: that’s the horizon each pod has to turn a profit. Retail investors cannot compete there, but pods forced short-terminism opens opportunities outside that universe.

In the long term, we are all dead. Sam didn’t have the luxury to reach there, he got fired earlier; investors have the same patience with active managers, if not shorter, than the 76ers management. By ‘active’ I mean strategies like value, trend following, non-US equities and so on. This is where, potentially, opportunities may arise for patient investors.

A league with 30 intense competitors requires a culture of finding new, better ways to solve repeating problems. In the short term, investing in that sort of innovation often doesn’t look like much progress, if any. Abraham Lincoln said “give me six hours to chop down a tree and I will spend the first four sharpening the axe.”

I admire Seth Klarman a great deal. I am consistently impressed by his conviction and humility, a rare combination.

Conviction and humility. You need both but you also need to understand when to employ one or the other. Conviction is the ability to hold contrarian views; humility is accepting that we might be wrong. In investing, there is rarely a clear winning strategy; and when it manifests, it is too late to act on it. Even the Equity Risk Premium is not certain and I fully understand how this statement can be a blasphemy for many today.

to divorce process from outcome. You can be right for the wrong reasons. In our business, you’re often lionized for it. You can be wrong for the right reasons. This may well prove to be Joel Embiid. There is signal everywhere that Joel is unique, from the practice gyms in Lawrence, Kansas to Bala Cynwyd, Pennsylvania to Doha, Qatar where he does something awe inspiring far too regularly. We remain hopeful (and optimistic) about his long-term playing career, but we don’t yet know exactly how it will turn out. The decision to draft Joel third, though, still looks to me to be the correct one in hindsight given the underlying reasoning. But to call something that could be wrong (“failed draft pick”) right (“good decision”) makes all of our heads hurt, mine included.

I am not sure how many readers know the whole Joel saga but it is a great example on how is difficult to assess how effective a process is. Especially how alluring is to rely on a specific outcome. Joel had many ups and downs, hopefully more in the years to come. At each step, the final conclusion about The Process was inevitably drawn. Until the next step.

We talk a great deal about being curious, not critical. About asking the question until you understand something truly. About not being afraid to ask the obvious question that everyone else seems to know the answer to. And about the willingness to say three simple words, “I don’t know.”

The tremendous advantage of being part of a smart investment community (smarter than me, at least) is that your convictions are continuously challenged. There is a lot, A LOT, of noise out there but cultivating your little personal Investment Committee can lead to spectacular results.

A way to prop up this kind of humility is to keep score. Use a decision journal. Write in your own words what you think will happen and why before a decision. Refer back to it later. See if you were right, and for the right reasons (think Bill Belichick’s famous 4th down decision against Indianapolis in 2009 which summarizes to: good decision, didn’t work). Reading your own past reasoning in your own words in your own handwriting time after time causes the tides of humility to gather at your feet.

Keep a diary. Or a blog 😉

You don’t have a wobbly understanding of just the things you got wrong, but the things you got right but not right enough. Listen to Charlie Munger talk about how he and Berkshire Hathaway should be measured not by their success, but by how much more successful they would have been if they bought more of something: “We should have bought more Coke.”

To me, this passage is a strong nod to the issues with goal-based investing. You set aside some cash to buy a car in 5 years and when the time comes, you buy the car because you had the money. Mission accomplished.

Is so? Was there an opportunity cost? What if you designed the whole investment portfolio in a different way or if you introduced more flexibility around your spending? Isn’t having your car and some cash better than just the car? What if at year 3 your wife’s job got moved to London and now you car plan is in the bin because you do not need a car anymore? What if you have 3 kids instead of 2? What about 0 instead of 2 (considering that the correlation with “now you do not have a partner anymore” is quite high)?

In most endeavors, it’s fine to be content to woodshed until you get something near perfect. You want that to be you. Grit matters. But it won’t be long until some innovation makes all that effort newly obsolete. You want that to be you, too

This is the concept that throws off most investors: this time is really different. New edges come and go. If you are in the market for that then sure, exploration is the key. But what pays off for the rest of us is going the other direction, the bet on the eventual regression to the mean. Value doesn’t work until it does (or maybe not).

This one is tricky, and getting more so in a league as healthy and popular as the NBA that is covered by beat writers, columnists, bloggers, commentators, and fans minute-to-minute. If you want to have real success you have to very often be willing to do something different from the herd.

The key difference with the stock market is the beta factor. You are paid if you participate, i.e. you are able to stomach the volatility. But this is where it gets tricky: if you want to do better, you have to do something different…which is also what you need to do if you want to do worse.

Howard Marks describes this as a necessary condition of great performance: you have to be nonconsensus and right. Both.

But this is difficult, emotionally and intellectually. Seth Klarman talks about the comfort of consensus. It’s much more comfortable to have people generally agreeing with you. By definition, those opportunities in a constrained environment winnow away with each person that agrees with you, though. It reminds me of when we first moved to Palo Alto. Within about a week of living there a voice kept telling me, “This is great. Great weather, 30 minutes to the ocean, 3 hours to ski, a vibrant city 30 miles away, and one of the world’s best research universities within walking distance. People should really move here.” Then I looked at real estate prices. I was right, yes, but this view was decidedly not a non-consensus view. My viewpoint as a Silicon Valley real estate dilettante, which took a whole week to form, had been priced in. Shocker.

This is what makes me laugh when I hear “RE prices in city XYZ are nuts, better to live 3 hours away”. If this really works for you then great, you are arbitraging other people preferences for profit. More often than not, you are spending time (commuting) instead of money.

This weekend a London friend was telling me about one of her acquaintances who lives in Leeds. She had to move there because her office/job is there. She lives in this big house but her social life is in a secular bear market because…well, it is fucking Leeds. I am not saying there’s no happy lad living in Leeds, but you have to be that lad to be happy. Houses in Leeds cost like two cocktails in London because there are not that many. Supply and demand.

To develop truly contrarian views will require a never-ending thirst for better, more diverse inputs. What player do you think is most undervalued? Get him for your team. What basketball axiom is most likely to be untrue? Take it on and do the opposite. What is the biggest, least valuable time sink for the organization? Stop doing it. Otherwise, it’s a big game of pitty pat, and you’re stuck just hoping for good things to happen, rather than developing a strategy for how to make them happen.

Here Sam details a path to achieve ‘above benchmark’ results but I think the same roadmap can be used in personal finance in general. Diverse inputs can be diversification in investments but also in opinions, challenge your believes; stop doing stuff that are counterproductive, like constantly looking at you account balance and reading news instead of books.

There’s actually a key aspect that I would like to discuss here that I took from Daryl Morey: a basketball team is first…a team, meaning you cannot have 5 centers or 5 playmakes. Synergies are important and the team is capacity-constrained: it’s a 12 guys roster with 8/9 actually playing.

You cannot acquire a large number of undervalued players because only 5 can play at the same time anyway (even if you are paying them half of what the other team costs) and you need players that fit together. Also, considering that salaries are capped also on the upside, superstar players are also undervalued: the issue here is how you convince them to play for you.

Investment portfolios have the same constraints. Even if you employ leverage, there is a maximum amount you can stuff into them; I cannot write “the limit is 100%” because many would say and what about leverage?!? but at the end of the day, the limit is a form of 100%. You want stuff that works well together, even assets with negative EV (no, I will not tell you again the Dennis Rodman story). And do not fall into the trap of what they tell you ‘undervalued’ is: the classic example is to compare EU industrials (wrapped as EU indexes) with US tech (wrapped as the S&P500). Sure, multiples are different but it is not written anywhere that they should (and will) converge one day.

In some decisions, the uncertainties are savage. You have to find a way to get comfortable with that range of outcomes. If you can’t, you’re forced to live with many fewer options to choose amongst which leads over the long term to lesser and lesser outcomes.

Should you add gold to your portfolio? Will Bitcoin be still a thing in 5 years? And DOGE coin? Talking about crypto, I found this on Twitter:

While contrarian views are absolutely necessary to truly deliver, conventional wisdom is still wise. It is generally accepted as the conventional view because it is considered the best we have. […] The single best place to start is often wherever they [legends of the game] left off.

I can imagine that some of these sound contradictory: contrarian thinking, but respect for tradition, while looking to disrupt. That yin and yang is part of it—keep looking. Questioning.

I recently listened to Ted Seides interviewing Jonathan Glidden about his turnaround of the Delta Airlines pension fund. Sam’s plan when he joined the Sixers reminded me of the situation Jonathan faced and the way he approached it. Set the goals, define a plan to get there and acknowledge it is going to be a difficult journey requiring bold choices.

I strongly recommend you listen to the interview. Jonathan rode a once-in-a-lifetime wave of alpha-delivering private managers: hard to say how much survivorship bias is in there. But to his credit, he designed a unique and effective strategy; he knew he needed alpha to meet the fund’s target. Was he lucky? Maybe. But the process was definitely there.

We determined to play a faster style that recognizes the importance of speed in tomorrow’s NBA and one that quickly integrates young players. We set out to improve our shot selection toward high efficiency basketball. We also wanted to build a defensive identity that—in time—could thwart tomorrow’s high-efficiency offenses. Lastly, we needed to build a world-class training center, develop an ever-evolving player development program, and change the organization’s culture to one of innovation and a constant search for competitive edge.

For many, valid, reasons “innovation” represents a bad word in retail investing. It is sad. My hope is to foster a culture that wants to try new things…in the right way. No excesses or maxis. Neither a boomer fear of “everything is a fraud”. Big gains are for early adopters; even when things do not work out, early adopters have a good dose of fun and excitement. Exploration should become a part of who you are, which is different from being the new joiner of the next cult.

This relates as well to what Sam calls “a larger quiver”. I studied and researched US-listed ETFs for many years while I was in no position to invest in them. And then the opportunity arrived.

Was Sam’s plan worth it?

It is hard to say. Not only because Sam was fired before he could fully reap the fruits of his strategy (as said, the next GM rushed to spend all the salary cap Sam created…not necessarily for the best, thinking how Tobias Harris never really produced) but also because luck is a big part of the (draft) game. The San Antonio Spurs managed to suck for precisely two seasons and secured two first picks exactly when two universally recognised generational talents were up for grabs. Two players that, so far, dodged any career-ending injuries.

Another Sam, Presti, is definitely punching above his weight running a small market team like the Thunders to great results. He’s doing so while he perfected Hinkie’s plan. Tanking is good to improve draft odds but culture-crashing. Presti realised that: while in “rebuilding mode”, he never lost on purpose but decided to acquire picks from teams that would ultimately suck while thinking of being on a path to greatness. It is the best of both worlds because you can still pick high and grow a winning identity.

The good news for retail investors is that no one other than yourself can fire you from the job. You can take the longest view and be patient with your strategy.

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