Taos believes there is a bias to the markets. Much of modern investing is based on the Nobel Prize winning theory called Modern Portfolio Theory (MPT). This is still taught in every business school. MPT makes certain assumptions, specifically perfect markets and perfectly rational participants. By perfect market, the theory assumes unlimited liquidity, unlimited leverage, instantaneous information, easy shorting, and so on. Based on MPT, fundamentals equal equity performance. The Dividend Discount Model provides the correct value for a company; it is the discounted sum of its future cash flows. Finance theory makes assumptions that allow the models to work out nicely without loose ends. However, under uncertain conditions, it makes sense to question the theory’s applicability.
As Dr. Robert Schiller (Yale), Dr. Andrew Lo (MIT), Dr. Robert Haugen (UC, Irvine), and others have shown that the markets are imperfect and volatility is significantly higher than fundamentals account for. In other words, Fundamentals + X-Factor = Security Performance.
A portion of this X-Factor can be explained using behavioral finance attributes. History has shown that market participants in large numbers can behave in a non-rational manner in certain situations. As the recent technology and housing bubbles have shown, there is some level of predictability to the human behavior that distorts markets. There are also predictable behaviors by professional asset managers. This X-Factor is what makes markets inefficient and allows for positive risk adjusted returns to be achieved.
Taos believes successful long-term investing is based on methodical processes that find investment opportunities that are asymmetric in their respective payoff. If the investment thesis is correct, the investment produces a nice return. If the investment thesis is wrong, only a small loss is incurred. This is very similar to the payoff of a call options, finite knowable downside with unlimited upside. Taos attempts to use quantitative methods as a starting point to finding these opportunities.
How Taos finds situations that pay asymmetric payoffs is our Investment Process. The firm has developed investing strategies that have favorable payback distributions. While Taos will not reveal what is inside its quantitative screens, it will divulge the idea. Warren Buffet said it first, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact.” Confirming this idea is a 2009 study by Kaplan, Sensoy, and Strömberg called “Should Investors Bet on the Jockey or the Horse?” The study suggests that at the margin, investors should place more weight on the business (“the horse”) than on the management team. What the the quantitative model tries to ascertain is good and bad horses.
Once businesses are selected, Taos does not blindly follow the models, turning over all decision making. Instead, we utilize both quantitative results and traditional fundamental analysis. In particular, Taos wants to make sure that the metrics are accurate and representative of future expected results.
For most of the securities, commodities, and currency markets, the starting point is a quantitative screen based on a tested strategy. Special situations present an exception because by their very nature they are difficult to screen for. Quantitative idea generation is focused on finding securities that are either undervalued or overvalued. If the Investment Process used the press, investor conferences, or sell-side research, it would generally be receiving old news. The objective is to find ideas that are not yet in the spotlight, but will be in the future.
Taos has developed comprehensive and consistent information gathering practices that create alerts for potential special situations. Examples of special situations are: spin-outs, mergers, legal situations, index changes, and other events that present investment opportunities that are outside the norm. Also, Taos would classify deep value investing as a special situation because they are generally passed over by the investing community.
Following quantitative screening, a fundamental review of the company or commodity is conducted. This is to ensure that the current state of the company or commodity market matches the factor model used when screening. Since the factor model is based on historical items, Taos seeks to ensure that nothing has changed in between the financial data and present status.
For special situations, Taos conducts in-depth fundamental research to see if there exists an interesting investment opportunity. The amount of raw research time spent is probably the highest on special situations versus any other investment decision made.
Based on research, the most attractive securities from a risk-reward perspective are added to the portfolio. Taos has a bias toward equity and equity-linked securities for individual companies because of the more favorable payoff characteristics. Fixed income has asymmetric payoffs that Taos generally seeks to avoid. However, we believe there are situations worth attention in fixed income, though not often. For commodities, listed futures are favored for their low costs and tax characteristics.
Once a security is chosen, position size is decided based on the expected return, level of acceptable risk (both individual security and overall portfolio), and desired overall portfolio positioning. Taos does not seek to match long investments and short positions in any manner. Considering these separately increases the likelihood of positive returns on both our long and short investments. The Long-Short portfolio is positioned more aggressively both long and short than the Long-Only portfolio. The Long-Only portfolio is conservatively positioned; between 0% and 100% long (0% being 100% cash, and 100% being 100% invested).
Taos adjusts position sizes based on changing expected payoffs of that particular investment and how the overall portfolio is positioned. To decide the net portfolio positioning both in dollar and beta terms, Taos uses several proprietary quantitative models that create the framework for making this decision. The main factors driving overall portfolio position are: macroeconomic data, sector analysis, market valuation levels, and sentiment. In some situations, Taos may use exchange-traded instruments to change the portfolio’s stance for the short term.
Taos expects to have a high level of activity (portfolio turnover) and could be subject to high levels of short-term gains. In general, short-term gains are subject to higher income taxes than long-term capital gains. Additionally, the complexity in filing taxes is higher with more transactions.