How to Construct a Behavioural Edge
As a long term investor our efforts are focused on finding companies capable of increasing their intrinsic values through their own efforts. Ideally, we are trying to identify high quality businesses facing short term, but surmountable, problems, but whose attractive long term prospects are intact.
In the short term there can often be little correlation between price and value, or stock success and business success but over the long term this correlation is high; this disparity is the key to making money, but it can persist for long periods of time. Discipline and patience are required to exploit these price/value discrepancies.
As long term investors we can take advantage of the time arbitrage afforded to patient investors with patient capital. While the informational source of edge for professional investors has decreased over time, the ongoing shortening of security holding periods has increased the advantage of time arbitrage for long term investors. By focusing on quality companies we can benefit from those companies’ intrinsic value appreciation.
“In my experience alternative approaches that necessitate the prediction of sharp asset re-ratings, and the identification of catalysts that will cause these, are meaningfully more difficult to execute.”
By owning a portfolio of businesses steadily compounding the value of their economic earnings, we are tipping the odds of earning a satisfactory return on our equity ownership in our favour.
Meanwhile we can exploit stock market volatility to manage the portfolio in a way that may augment this underlying business value compounding. The average difference between the 52 week high and the 52 week low stock price for US large caps is 50%! This vastly overstates the likely difference in private business valuation from one year to the next.
I expect the change in underlying per share value of portfolio holding companies to do most of the work for me in delivering acceptable annual investment results, but sensible and occasional portfolio management decisions should enhance these returns over the long term.
Process: competitive advantage
So we are looking for businesses that can sustainably create value through their own efforts. This means finding companies that can earn economic profits in excess of the cost of the capital employed to generate those profits. We want companies that can do this sustainably. In the absence of lasting unfair advantages, the entry of new capital and intelligent effort will drive returns towards to the cost of capital. This capital cycle economic theory is academically and empirically broadly accepted.
There are two ways to potentially profit from this capital cycle. The first is to invest in the mean reversion of returns to cost of capital levels. This requires the ability to time the entry and exit of capital within an industry, and the catalysts that might give rise to a change in returns on capital e.g. the closure of factories, industry consolidation or bankruptcies.
In addition this requires ‘renting’ the stock for a period of the capital cycle when the market is extrapolating forward financial performance that is likely to mean revert. For these two reasons, this approach is inconsistent with an investment programme which has long term business ownership as the cornerstone of its investment philosophy.
The second approach is to identify companies whose supernormal profit potential is larger and more sustainable than the market believes. This is consistent with the recognition that patient temperament and capital are important sources of edge in executing a long term investment strategy.
Assessment of business quality involves gathering evidence that supports or refutes the existence of an economic moat, developing an understanding of the factors that have created this moat and whether the moat is likely to narrow or widen in the future. This involves a close examination of management’s incentives and capital allocation ability.
Management must be able to sensibly compare the value of various capital allocation choices. A rigid cash use ranking will not do. Dividends are value destructive if they are made in lieu of available positive NPV investments1. Share repurchases are value destructive if shares are acquired at market quotations materially above intrinsic value. Asset growth shrinks per share business value if incremental cash returns are below the opportunity cost of capital.
While an appreciation of frameworks such as Porter’s Five Forces is useful in understanding competitive dynamics within various industries, it is important to safeguard against an overly prescriptive employment of these frameworks. Sometimes investors seem very keen to apply a ready-made label to the source of a company’s moat e.g. switching costs, network effects, intangible assets, cost advantages and so forth.
Execution: making better decisions
We, fund managers, should be in the business of creating, not transferring, value. In the pursuit of this goal investors’ capacity to make good decisions is taken for granted. Making good decisions is not commonly considered a source of edge.
“As investors we are frequently encouraged to consider the edge that will allow us to outperform markets.”
The debate surrounds the trio of informational vs. analytical vs. behavioural source of competitive advantage. In our experience most investment firms are focused on the first two.
This is partly due to a mandate to gather assets vs. delivering superior investment returns. Undue weight is given to what looks good in a pitch book vs. what works. In a world in which data has been rapidly democratised, a focus on informational edge can encourage excessive spend on travel/corporate access/over the top or misdirected primary research.
Analytical edge may be possible, but a belief that we can more intelligently analyse information than our very smart and experienced peers can open the door to overconfidence and hubris. When we become overconfident, we become unreceptive to evidence that contradicts our opinions. It is important to develop strategies and systems to ensure we remain sceptical of our own views and attentive to the facts and evidence that may support or refute them.
“One such strategy is the recognition that behavioural edge is the most obvious opportunity to make better decisions and earn better returns over the long term.”
Behavioural edge is about creating a culture and environment that gives us the best chance of making optimal decisions. Optimal decisions are those that allow us to satisfy our goals of creating rather than transferring value, and of solving our partners’ problems.
It is predicated on a belief that we can tip the odds in our favour over time by repeatedly making good choices day in, day out. These decisions can relate to how we organise our day, where we focus our efforts, when to start and stop research, whether to invest, how much to invest, when and how much to sell, forming views of management, staffing, office location, investment partners, and designing fee structures.
The organisation of roles and responsibilities within large asset managers can lead to overconfidence. Sector focused analysts (focused on analytical rather than behavioural edge) have a small investment universe but are forced to pick winners and losers. This narrow focus can encourage excessive data collection and detailed financial forecasting, leading to overconfidence. The segregation of roles can impede rational decision making too.
Diligent and thoughtful fundamental research on the handful of factors that matter is a pre-requisite rather than a source of edge. But one should acknowledge the diminishing or even negative returns of more information. Industry incentives are inconsistent with epistemological humility; pressure to sound smart is highlighted by the widespread practice of detailed financial forecasting.
The design and implementation of thoughtful incentive structures is crucial to being able to faithfully execute a genuine long term investment strategy. Fee structures should avoid the undesirable outcome that investment managers can become rich by delivering below cost of capital returns to investment partners.
Hurdles or investment rebates can help to achieve this aim. Investment managers without skin in the game face a major impediment to good decision making, because it makes it harder to fight the asset gathering imperative in pursuit of a returns-focused investment objective.
Entrepreneurs often say that execution is more important than ideas. The same is true of investment strategies. The ability to execute a strategy is more important than the uniqueness or marketability of that strategy (for performance, not necessarily for gathering assets). So it’s important to think about how we can best execute our strategy. There are no points for difficulty or originality in this business; there are points for making decisions that lead to satisfactory long term returns for our partners and clients.