Investing is not as hard as we think A polite assassination of the - - PowerPoint PPT Presentation

A polite assassination of the behavioural shortcomings of our competition

Investing is not as hard as we think

Value Investing Speaker Series LBS Investment Management Club February 2019

Disclaimer

The contents of this document are communicated by, and the property of, Tollymore Investment Partners

• LLP. Tollymore Investment Partners LLP is an appointed representative of Eschler Asset Management LLP

which is authorised and regulated by the Financial Conduct Authority (“FCA”). The information and opinions contained in this document are subject to updating and verification and may be subject to amendment. No representation, warranty, or undertaking, express or limited, is given as to the accuracy or completeness of the information or opinions contained in this document by Tollymore Investment Partners LLP or its directors. No liability is accepted by such persons for the accuracy or completeness of any information or opinions. As such, no reliance may be placed for any purpose on the information and opinions contained in this document. The information contained in this document is strictly confidential. The value of investments and any income generated may go down as well as up and is not guaranteed. Past performance is not necessarily a guide to future performance.

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About Tollymore

T O L L Y M O R E I N V E S T M E N T P A R T N E R S Tollymore's objective is to compound clients' capital over the long term by investing in a concentrated portfolio of undervalued high-quality businesses. Patience and independent thought are cornerstones of

• ur investment philosophy. Tollymore seeks to improve the lives of investors through exceptional long-

term investment returns. M A R K W A L K E R , A C A , M A N A G I N G P A R T N E R A N D P O R T F O L I O M A N A G E R Mark Walker is the Managing Partner of Tollymore Investment Partners. Prior to founding Tollymore Mark was a global equity investor for Seven Pillars Capital Management, a long-term global value investing firm based in London. Mark joined Seven Pillars from RWC Partners, where he was part of a two-person team managing a newly launched, long term global equity fund. Prior to that Mark worked as an investment research analyst for Goldman Sachs and Redburn Partners. He is a qualified chartered accountant, and graduated from Edinburgh University with a First Class MA Honours degree in Economics, graduating first in his class.

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Investing IS hard

“ It’ s not suppos e d to be e as y. Anybody w h o finds it e asy is s tupid” . Ch arlie Munge r

• Active trading harms aggregate investment results (Journal of Finance)
• Over the last 15 years only one in 13 large-cap managers, only one in 19 mid-cap

managers, and one in 23 small-cap managers were able to outperform their benchmark index. (SPIVA)

• Investors underperform both the passive and active funds in which they are

invested (Morningstar surveys)

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But we know it’s hard

A frame w ork to s tay th e c ours e in pe riods of se lf -doubt

• We know investing is hard. We are here because we think we can make a difference.
• Spending time with reflective thoughtful and talented peers can lead to imposter

syndrome!

• We need a broader context in which to judge our prospects for long term success.
• My sell side experience exposed me to the incentives and actions of the institutional

money management industry.

• The following is a collection of eight observations from that experience.
• For each behavioural constraint I’ll discuss my personal impressions as well as “the
• utside view”, why this may be antithetical to sound investing practice, and how we

can set ourselves up to avoid and exploit these behavioural errors.

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(1) Pursuit of informational edge

O bse rv ations

• Corporate access perceived as a source of edge for the largest managers.
• Corporate access led investment processes.
• Large complex financial models, broad knowledge vs. deep understanding.
• Lack of calibration of investment processes to forecasting errors.

W h at’ s th e proble m?

• Information gathering increased confidence but not accuracy.
• Exposure to sales pitches.
• Misdirected intellectual effort/intellectual dishonesty.

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(1) Pursuit of informational edge

Th e outside v ie w

• Overconfidence can have profound consequences, inflating investors' valuation of their

investments, leading physicians to gravitate too quickly to a diagnosis, and making people intolerant of dissenting views.

• Numerous studies suggest that confidence and accuracy are not highly related. E.g. College

football experts were asked to predict game outcomes (Organizational Behavior and Human Decision Processes), professional horse handicappers predicting horse races (Paul Slovic). In subsequent rounds of the game the experts were given additional information and asked to rank their confidence. The additional information did not improve the accuracy of their predictions but did increased the confidence in their bets.

• The problem with this as it relates to investing is that the extra confidence causes us to

increase the size of our bets without a corresponding increase in our capacity to predict

• utcomes, causing us to lose money.

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(1) Pursuit of informational edge

Th e outside v ie w

• Overloading our cognitive capacities

with more information can actually lead to worse decision making. In one study 60% of participants chose the

• bjectively best car when given four

attributes, vs. a 20% success rate when given 12 attributes (Dijksterhuis).

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(1) Pursuit of informational edge

How to av oid/ e xploit

• Awareness of exposure to sales pitches.
• Corporate access position in an investment process.
• Strive for simplicity and conduct deep work on the handful of value drivers.
• Large opportunity set and focused portfolio to find the biggest gaps between price

and (wide) value range.

• Consider the merits of equal weighted portfolios if overconfidence is likely to cause us

to increase bet size.

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(2) Pursuit of analytical edge

O bse rv ations

• Specialists vs. generalists.
• Sector teams and incentives directed to picking winners and losers.
• Self-perceived expertise fosters hubris and certainty.
• Absence of probabilistic thinking.
• Unreceptive to disconfirming evidence or dissenting opinions.
• Conviction differences in analysts vs. PMs
• Intellectually closed and believe that ideas, IQ and research = edge.
• Authority bias: Hierarchical structures.
• Synonymity of titles and progress.
• Committee led decision making.
• Investment managers feel the need to sound smart, a major barrier to epistemic
• humility. “It ain't what you don't know that gets you into trouble. It's what you know

for sure that just ain't so.” (Mark Twain (mis?)quote)

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(2) Pursuit of analytical edge

W h at’ s th e proble m?

• The need to justify fees creates pressure to:
• Conceal rather than acknowledge ignorance, and
• Build large teams and create perception of deep intellectual expertise. This

expertise increases the perceived validity of one’s own opinions and makes

• ne less receptive to ‘non-experts’. Deep perceived expertise promotes trust

in intuition and lowers the inclination for hard System II work.

• This also geometrically increases complexity of organisations, introduces group

think, authority bias, loss aversion by slowing down decision making – are we acting decisively when the odds are in our favour?

• Large teams dilute decision-making accountability, leading to mis-assignment of

skill and stupidity vs. luck and therefore hubris.

• Smarter people are worse at combatting behavioural biases (Kahan motivated

reasoning trap – numerically literate people fit the data to their pre-existing views on gun control).

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(2) Pursuit of analytical edge

Th e outside v ie w

• Greater accuracy is attributed to the opinions of authority figures (Milgrim’s effort to

understand why moral humans commit atrocities – half of subjects administered fatal electric shocks in conflict with personal conscious).

• The preference for orderly social systems trains us from birth to obey authority;

deference to authority is mindless.

• Mental flexibility, introspection, and the ability to properly calibrate evidence are at

the core of rational thinking and are largely absent on IQ tests. Typical decision makers allocate only 25% of their time to thinking about the problem properly and learning from experience (Mauboussin). Most spend their time gathering information, which feels like progress and appears diligent to superiors. But information without context is falsely empowering.

• HiPPO (highest paid person’s opinion) is a barrier to data/evidence based decision
• making. Peer acquiescence further entrenches the HiPPO’s confidence.

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(2) Pursuit of analytical edge

Th e outside v ie w Some prominent examples of the HiPPO effect from Forbes authors DeRose and Tichy:

13 Ron Johnson joined JC Penney as CEO having successfully pioneered Apple’s Apple store concept. [Johns nson]

• n] not only ignor

nored d existing ting data, ta, but he was also convinced he didn’t need new information formation to vali lida date the righ ghteo teousn sness ss of his strate ategy

• gy. Although

encouraged by the company’s retail veterans to do so, Johnson decided not to test any of his changes because Apple had never tested when growing its store

• network. Experimentation in a small number of stores is common practice in

retail before nationwide roll-outs. Had Johnson been interested, surely experiments would have provided an early warning that his strategy wasn’t sitting well with customers. Once execution of the company’s new direction was underway, Johnson did reportedly ask frequently “is it working?” It’s not surprising that few w had d the coura rage ge to speak ak up and give Johnson an unvarnished dose of reality. The former CEO like iked d to tell l employ loyees s that there were two kinds nds of peopl ple – skeptic ptics s and d beli lieve vers

• rs. At Apple, Johnson said, there were only believers and he expected the

same at JCP. It’s not hard to imagine emplo loyees s heari ring ng that messa sage ge loud d and clear ar – speak up and you’ll be labeled as a resister. Amazon succumbed to authority bias when it launched its Fire Phone: After talking to more than a dozen Amazon employees, Carr puts the failure squarely at the feet of Amazon CEO Jeff Bezos, suggesting Amazon’s hardware development issues may run deeper than previously

• thought. As Carr tells it, the Fire

re Phone ne succumbed d to mispl placed d ambiti itions

• ns and

d micro romana anage gement nt from

• m

Bezos s [who]

• ] obsess

ssiv ively ly moni nitor

• red

d the project. “Even the very smallest decisions needed to go through him,”

• ne Amazon employee told Carr. By the end, the team

had d given ven up buil ildi ding ng a phone ne for r consum sumers rs and d shifted building one that would satisfy Bezos’s ambiti itions

• ns.

(2) Pursuit of analytical edge

Beware of group think (Asch Conformity Experiments):

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(2) Pursuit of analytical edge

How to av oid/ e xploit

• Teams should be small (accountability, simple communication structures).
• Teams should be diverse. Diversity adds different perspectives and also makes it easier for

individuals to say what they really think. The independence of opinions is a prerequisite for collectively wise decisions.

• Have a large universe and a concentrated portfolio obviating the need for valuation

precision, which requires analytical edge.

• Embrace uncertainty and express views probabilistically. If you were forced to bet would

you calibrate the certainty with which you express your opinion?

• Embrace spirit of intellectual generosity with likeminded peers. Seek dissenting opinions.
• Employ flat structures and anonymous voting mechanisms.
• One-person investment committee.
• PMs = analysts
• Consider the incentives of those providing advice.

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(3) Pitchbook mentality

O bs e rv ations

• Marketing- vs. efficacy-based strategies and investment processes.
• Niche investment universe → analytical edge
• Primary research.
• Idea funnels.
• Research teams → analytical edge.
• Expression of certainty in meetings and research.
• Managers need to show clients they are earning their fees → action bias.

W h at’ s th e proble m?

• Asset gathering business objectives and gold-plated cost structures magnify the imperative to

grow AuM. Investment firms are led by marketers rather than investment managers.

• The strategy is tailored to what will sell rather than what works.
• High industry fees pressure investment firms to develop complex, niche strategies.

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(3) Pitchbook mentality

Th e outs ide v ie w

• Action bias: When faced with a penalty kick goalkeepers staying in the centre stopped one

third of all kicks, while those who jumped stopped half as many. If the odds say doing nothing is far superior to jumping, why do goalkeepers jump 96% of the time? (Bari-Eli and Gurion).

• Other examples: changing supermarket queues, taking a detour in traffic, trading investment
• portfolios. Trading frequency is negatively correlated with returns (Barber and Odean).
• "Our stay-put behavior reflects our view that the stock market serves as a relocation center at

which money is moved from the active to the patient.” Warren Buffett How to av oid/ e xploit

• Match the investment strategy to the manager’s capability and temperament.
• Focus on returns vs. assets.
• Focus on what works vs. what looks good in a marketing deck.

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(4) The folly of forecasting

O bs e rv ations

• Strong focus on having the most accurate numbers. Incentives and behaviours directed to

predicting the future.

• This led to relative outperformance vs. peers but dismal absolute performance.
• Obsession with consensus: an Ashton Partners study revealed 30% of PMs think consensus

estimates are very important and 70% said somewhat important. None said they were not important. W h at’ s th e proble m?

• Markets and economies, unlike meteorology, are complex and reflexive; participants are second-

guessing one another and the bases on which decisions are made are altered by the decisions themselves e.g. if inflation is predicted to increase, workers may demand higher wages; did the

• riginal prediction incorporate this feedback loop?
• The volatility of stocks makes it very difficult to predict short term price movements.

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(4) The folly of forecasting

Th e outs ide v ie w

• Based on a sample of 63 industrial and

developing countries, a study by Prakash Loungani at the IMF showed that private sector forecasters were only able to predict two of the past 150 recessions.

• Phil Tetlock collected 28k predictions

from 284 experts; he found that the average expert’s forecasts were only slightly more accurate than random guessing.

• In chess, a materially simpler reflexive

model, there are 10 to the 120th power possible moves.

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Strategists can’t predict markets:

(4) The folly of forecasting

Th e outs ide v ie w

• Consider Keynes’ Beauty Contest

requiring multiple level thinking:

• Guess a number from zero to 100, with

the goal of making your guess as close as possible to two-thirds of the average guess.

• Wide dispersion of results.
• Spikes at the first level thinker at 33,

second level thinker at 22, third level thinker at 15, and the Nash equilibrium

• f zero.

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(4) The folly of forecasting

Th e outs ide v ie w

• Stock market volatility declines as holding periods increase; predicting short term share price

movements is a low ROI exercise:

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(4) The folly of forecasting

How to av oid/e xp loit

• Don’t attempt to understand and analyse the market’s thoughts.
• Conduct independent research and do not rely on sell side models and

forecasts.

• Estimate the ranges of the company’s future private business value vs.

whether it will beat or miss consensus estimates.

• Focus on long term, lower volatility outcomes.

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(5) Manager/investor misalignment

O bse rv ations

• Managers not invested in the funds they managed.
• High management fees and no performance fees.
• Performance fee structures dictated by a strategy rather than the capacity to compound

capital and acknowledgement of the power of incentives. W h at’ s th e proble m?

• Managers’ and investors’ fortunes are typically not aligned. This is a barrier to sound

investment decision making.

• A simple way to weed out the managers that back themselves is to consider the presence and

power of incentives – insider ownership and appropriate fee structures. Do the components

• f stewardship reflect a strong belief in the strategy or a product to be sold?
• Managers without insider ownership are less incentivized to limit the size of their fund,

therefore limiting their achievable time weighted return.

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(5) Manager/investor misalignment

Th e outs ide v ie w

• Studies have shown that insider
• wnership is one of the few statistical

indicators of performance; size of insider interest is positively correlated to returns; funds 100% owned by insiders generate 4.3% annualized excess returns vs. 0% insider

• wnership, factor-adjusted (Kinnel;

Gupta & Sachdeva).

• Founder led businesses are long term
• riented – higher R&D, capex and sales

growth.

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Founder led companies generate more value:

(5) Manager/investor misalignment

How to av oid/ e xploit

• Skin in the game. Construct an incentive structure in which a manager’s

compensation is driven by the compounding rates on his own capital as well as fees. Forgo management fees on additional capital in lieu of greater excess returns on privately invested capital.

• Fee structures that reward performance and coordinate manager and investor

enrichment.

• Employ hurdles to make weak performance cheap and strong performance

expensive.

• Management fees should facilitate stress-free investment and business decision

making.

• Transparent investor communication. Tell partners what’s in the portfolio, not what

you ‘think’.

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(6) Career risk and loss aversion

O bse rv ations

• Rhetoric about long term fundamental stock picking abound.
• But inevitable focus on quarterly earnings, concern over consensus and near-

term share price direction.

• Bloomberg budgets to keep an eye on markets, share prices and news flow.

W h at’ s th e proble m?

• Behaviour led to predicting share price movements/using the share price as a

signal of value.

• Consistently market-lagging estimates.
• Benchmark hugging.

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(6) Career risk and loss aversion

Th e outs ide v ie w

• In 2017 the European markets regulator Esma found in one investigation that one sixth of fund

managers were overcharging clients due to benchmark-hugging, including some of the biggest asset managers in the world.

• The FCA has estimated > £100bn of investors’ money is invested with benchmark-hugging

funds.

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• Cremers and Petajisto found those funds

with the highest active share

• utperformed their benchmarks by 1.1

ppts pa and those with the lowest active share underperformed their benchmarks by 1.4 to 1.8 ppts pa.

• Selective, long term managers
• utperform their benchmark-hugging,

short term peers:

(6) Career risk and loss aversion

How to av oid/ e xploit

• Build a long term aligned investor base with a business owner mentality, capable
• f tolerating periods of benchmark underperformance.
• Assemble the capital and working environment that will allow you to act

decisively when the odds are in your favour.

• Create an environment that allows the manager to both average down and

acknowledge mistakes.

• Surround yourself with intellectually generous peers and investment partners.
• Ditch the Bloomberg, or physically remove from your desk.

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(7) Short term capital

O bse rv ations

• Entrenched LP base, difficult to organically improve investor quality.
• Asset gathering mandate leading to unidirectional manager due diligence.
• Reputations affected by unhappy investors.
• Procyclical capital flows.

W h at’ s th e proble m?

• Short and declining holding periods drive pressure to guess share price

movements.

• Annual incentives and lack of insider ownership encourage professional

money managers to trade frequently.

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(7) Short term capital

Th e outside v ie w

• Stocks are long term investments,

yet the average holding period is eight months (Ned Davis Research):

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(7) Short term capital

How to av oid/ e xploit

• Performance fees lower pressure to raise substantial assets.
• Opportunity for emerging managers to organically develop an aligned and

sympathetic investor cohort by through two-way relationship building.

• Focus on building substantial behavioural edge through an educated LP

base capable of investing countercyclically over the long term.

• The long-term investor can purchase securities from sellers selling for non-

fundamental reasons (redemptions) or because they think news flow will be temporarily negative (they have an eight month holding period).

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(8) Communication style

O bse rv ations

• Short attention spans and competition for attention.
• Limited investment research real estate.
• Limited time (the hoot, fund manager attention span).
• This drove eloquent, memorable theses which sounded believable, but cut out

data.

• Analysts are trying to convince PMs, sell side is trying to convince the buy side,

traders, sales people. Incentives are directed to having our ideas believed.

• Monthly letters offering explanations for prior market movements,

highlighting ignorance of the complexity and reflexivity of markets, and adding no value.

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(8) Communication style

W h at’ s th e proble m?

• Stories emanate from our continuous attempt to make sense of the world. As such

they serve a purpose. The problem comes when we conflate explanatory power and predictive power. Half of the companies in Built to Last have suffered a significant fall from grace since the mid ’90s*.

• Story construction itself is problematic due to self-serving bias: favouring decisions

that enhance self-esteem. This results in attributing positive events to oneself and conversely negative events as blame on oneself.

• Compelling stories have characteristics that are antithetical to truth finding. They are

simple, ascribe outcomes to talent and stupidity vs. luck, focus on things that happened vs. things that failed to happen.

• The illusion that we understand the past fosters a belief that we can predict the future

(see the Folly of Forecasting).

*The 18 companies were 3M, American Express, Boeing, Citigroup, Disney, Ford, General Electric, Hewlett Packard, IBM, Johnson & Johnson, Marriott, Merck, Motorola, Nordstrom, Philip Morris, Procter & Gamble, Sony, Wal-Mart

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(8) Communication style

Th e outside v ie w

• Narrative Fallacy is the backward-looking mental drive to attribute a cause-

and-effect chain to our knowledge of the past. Without searching for reasons, we would go around with blinders on, one thing simply happening after

• another. This helps us make sense of the world despite sensory overload.
• However, it can cause us to make poor decisions. The power of narrative

causes us to violate probabilities and logic.

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(8) Communication style

Th e outside v ie w From Thinking Fast and Slow:

The best-known and most controversial of our experiments involved a fictitious lady called Linda. Amos and I made up the Linda problem to provide conclusive evidence of the role of heuristics in judgment and of their incompatibility with logic. This is how we described Linda: Linda is thirty-one years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations. We asked this simple question: Which alternative is more probable?

• Linda is a bank teller.
• Linda is a bank teller and is active in the feminist movement.

85% to 90% of undergraduates at several major universities chose the second option, contrary to logic.

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(8) Communication style

How to av oid/ e xploit

• Write involved, long shelf life letters to partners.
• Write about the fundamentals of the businesses you own and why you own

them.

• Don’t write about market or stock price movements, nor offer explanations for

these to encourage business owner mindset.

• Write infrequently or ideally irregularly, dictated by having something to say

rather than industry norms.

• Don’t pitch ideas but write research which collects and assembles facts, data

and logic.

• Profit from the narrative fallacy by specifically seeking out stocks without

good stories, or those with bad stories. This, rather than rates of growth and P/E multiples, is the essence of value vs. glamour investing.

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Mark Walker ACA Tollymore Investment Partners LLP www.tollymorepartners.com mark@tollymorepartners.com

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