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In this Article, Dr. Simon Marais, CIO of Allan Gray Australia, pens one of the most important articles on investment management that we have had the pleasure of reading. This article also appeared on www. moneymanagement.com.au.
Every investment management firm claims it is different from its competitors. Yet many firms produce results that are anything but different. What does it mean to be contrarian?
At its heart, an active fund manager’s proposition should be simple – to provide a service that is distinct, transparent and has a sustainable advantage over a passive approach. If these criteria are not met, a manager does not deserve its management fee. While apparently simple, these criteria present a deceptively high hurdle. The question, then, is how to identify an approach that offers a sustainable advantage and is transparent, yet is difficult to replicate? This paper identifies four key principles that form natural parameters to ‘outside the box investing’. Most investors will be unwilling or unable to apply them diligently. But, those who do can enjoy a competitive advantage and a rewarding and sustainable strategy.
1. Make alignment of interest a key principle
For investors who engage fund managers or advisers in their investment activities, alignment of interest is of critical importance. And fund manager career risk – the risk of being fired by a client or employer for relative underperformance versus peers – is perhaps the most widespread threat to alignment of interest. The risk is that the investment manager places his/her own best interests (keeping their job) ahead of the client’s best interest (long-term investment outcomes).
Self-interest is a natural part of human behaviour, and not reserved solely for evil, money-grabbing personalities. Darley and Batson (1973) recruited seminary students for an experiment. Each was instructed to go to another building where they were to prepare and deliver a presentation, the topic being either seminary jobs or the story of the Good Samaritan. The subjects were given varied time pressure for their task. On the way to complete their task, they encountered a man slumped in a doorway (an actor), who moaned as they walked by. The experiment sought to find out whether the students would stop to help and whether willingness to help would be affected by time pressure to do well in a task (self- interest). The results were telling and the level of time pressure had a major effect. In ‘low hurry’ situations, 63 per cent of students stopped to help the man. In ‘high hurry’ situations, only 10 per cent stopped to help – some even stepping right over him. Even for religious students, self- interest can overpower the will to act in the best interest of others.
Jeremy Grantham articulated the concept succinctly in his April 2012 newsletter: “The central truth of the investment business is that investment behaviour is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority ‘go with the flow’, either completely or partially. This creates herding, or momentum, which drives prices far above or far below a fair price. There are many other inefficiencies in market pricing, but this is by far the largest.”
This poses a serious problem for investment managers. They can pursue with conviction active investment choices they believe will lead to the best long-term outcomes for clients while accepting the risk of being fired. Or they can accept limits on their active decision-making and performance expectations in return for a reduced risk of getting fired.
So what features can inform whether a manager’s self-interest is better aligned with its clients?
Ownership structure, co-investment and performance fees
Consistent implementation of an investment philosophy depends on an investment team being willing and able to fulfil it. It is therefore preferable that they are incentivised to pursue their investment convictions, regardless of whether their approach is in favour with the investment community. Ownership structure and co-investment may contribute positively in this regard. Institutional asset consultant, Towers Watson, has argued that employee ownership, co-investment and performance fees form an important ‘triangle’ in aligning interests:
- Employee ownership – (of portfolio managers) should be specific to the strategy they are responsible for. Alignment of interest is diluted if equity ownership is for a broader asset management firm with other strategies that the individual is not responsible for; or equity ownership is for a broader financial services firm where the asset management operation is only one of several divisions.
- Co-investment – ‘[It is preferable] to see structures where the portfolio managers and analysts have their own money invested alongside client assets in the portfolios they manage. This approach works best where all client portfolios are managed in an identical fashion.’
- Performance fees – ‘One of the key advantages of a performance fee structure is that the asset management firm does not necessarily benefit from asset growth if this is having a negative impact on performance.’ Care must be taken, of course, to ensure the structure is fair and reasonable.
Active protection of shareholder interests
Where managers represent a significant holding in a company, they have greater ability to influence decisions on governance issues. If they can demonstrate that they will use their influence to actively pursue shareholders’ best interests, it can add to their value proposition. However, the record for Australian shareholders on matters of corporate governance cannot be described as active. According to Dean Paatsch, founder of institutional governance adviser, Ownership Matters, Australian shareholders are too passive:
‘Australian shareholders are blessed with powers… they can vote directors off the board, but the average incumbent director gets 96 per cent of the vote. It is clear that shareholders are not 96 per cent happy … On pay in particular, there’s been roughly nine ASX 300 companies who’ve received a first strike – so 25 per cent or more shareholders who’ve voted against the report – but at the same time, the directors of those companies have been reinstalled with an average vote of roughly 96 per cent. So there really is not a strong connection between people making a protest vote against a nonbinding vote on the remuneration and on their stewardship of the company’. From an investor who truly believes in the business, however, one might expect a more active approach.
2. Think like a long-term business owner
Sharemarket investors often find it difficult to think like long-term business owners. Even if they consider themselves investors and not traders, the typical mentality seeks to buy a share in anticipation of a near-term rise in price as evidenced by the 11-month average holding period for ASX shares. Moreover, the constant flow of information on companies, markets and economies can overwhelm rational thinking. We humans have great trouble with appropriately weighing the importance of such information and making decisions based upon that, and we are vulnerable to reacting to ‘noise’. As Black(1986) put it: ‘The whole structure of financial markets depends on relatively liquid markets in the shares of individual firms. Noise trading provides the essential missing ingredient. People who trade on noise are willing to trade, even though (from an objective point of view) they would be better off not trading. Perhaps they think the noise they are trading on is information. Or perhaps they just like to trade. Most of the time, the noise traders as a group will lose money.’ Would a prudent business owner think in terms of ‘beta’, or jump from one company to another to adjust risk as markets change? Would they sell their business and reinvest the proceeds into bonds because a dynamic asset allocation framework dictates this? It is highly unlikely. But this reflects the gap between how a true business owner thinks and how the average sharemarket investor thinks. Thinking like a business owner is a simple concept, but one that is often lost due to short-term profit seeking and investor susceptibility to noise.
3. Avoid over-confidence and accept uncertainty
Standard risk models tend to assume that we know the expected return for our portfolio, but may not get to experience this return because random events occur over our investment horizon. One problem with this is the assumption that the expected return was right in the first place or, to put it more technically, that the method used to estimate the mean produced an unbiased estimate. For most investors, risk is not volatility, skew or kurtosis, but rather it is the bias in mean return estimate, which in turn can lead to overpaying for investments. To highlight this problem, consider the following common hypotheses as factors in expected returns.
a) A reasonable expectation for real longterm returns is 4 per cent to 6 per cent pa.
Looking at gross domestic product (GDP) per capita over time highlights two remarkable things. Firstly, very little was achieved between 100 AD and 1900 AD – just 43 per cent growth in GDP per head in 1,800 years or 0.02 per cent per annum. Secondly, in the past 100 years, GDP per capita has grown 10 times. With investing, many assumptions are based on studying the past 100 years in the hope it represents normality, but the truth is that we simply do not know. For example, if you take $1 in today’s money and discount it back 1,000 years, it would be worth 14.5 pico-cents in the money of the day, assuming 3 per cent inflation. If you then reinflate it using a 4 per cent real long-term return, it would be worth 100 quadrillion dollars or 3,000 times the market cap of the world sharemarkets. This shows that 4 per cent real returns may not be a reasonable assumption over the very long-term.
b) Broad sharemarkets always grow, in real terms, given enough time.
Surely we can expect at least some real growth to compensate for the fact that management retains half of all company earnings on average? Unfortunately, this might not be true either. In Triumph of the Optimists, Dimson et al found that over the 100 years from 1900, the median real dividend growth rate across 16 developed markets has been less than zero (-0.7 per cent) and this excludes Argentina and Russia (where investors lost all their capital). History shows that real growth is harder to come by than commonly believed.
c) A 20-year perspective is enough when investing in the sharemarket
An investment in equities made in 1950 or 1985 would have been fantastic at the end of a 20-year time scale. Unfortunately, investing in equities in 1930, 1965 or 2000 would have been very disappointing over the same time scale. The same can be said of the bond market. US 10-year bond yields performed terribly from 1960 to 1980, but the reverse is true from 1980 to 2010.
d) It is better to invest in a country with high economic growth.
Dimson et al looked at GDP per capita and real equity returns from 1900 to 2009 and found that countries with lower equity returns generally had higher GDP per capita growth – confirmed by the correlation between the two of -0.23. One practical implication is that history does not support a theory of investing in emerging markets simply because GDP per capita is growing fast. But perhaps 110 years is misleading. Perhaps there is still a relationship between GDP per capita growth and sharemarket performance over a decade. Credit Suisse (2010) compared per capita real GDP growth with real equity returns over 183 investment periods, each lasting a decade. Over the last four decades, the correlation between the two ranged from 0.61 to -0.14. Pooling all observations, the low correlation (0.12) between GDP per capita growth and real equity returns is statistically insignificant. An R-squared of 1 per cent reveals that 99 per cent of the variability of equity returns is associated with factors other than changes in GDP per capita. Even over intervals of a decade, the association between GDP growth per capita and sharemarket performance is tenuous.
e) High growth in an industry is good for investments.
Imagine going back to the early 1970s and assume you know IT will be a successful, high growth industry and that computers would become ubiquitous – and that the tobacco industry would suffer a shrinking market penetration and stifling government regulations. Armed with this perfect foresight, you buy the biggest two IT stocks of the time – IBM and Digital Equipment – and avoid the two largest Tobacco stocks – BAT and Philip Morris. In fact, this perfect foresight would not help. On a total return index based at 1 in 1973, the two tobacco stocks grew to over 100 on the index, whereas technology stocks reached 35. While it seems intuitive that industry dynamics and growth rates should correspond with equity returns, this is not necessarily the case. One reason why foresight proved so poor in this regard maybe that rapidly growing industries attract a rapidly growing list of competitors. IBM did not anticipate the growth in Microsoft, and Microsoft did not appreciate the threat posed by Google. In contrast, apparently unattractive industries tend to experience reduced competition and hence profit growth is often surprisingly attractive.
Commonly held beliefs and intuitive assumptions often lead to over-confidence and an underestimation of the level of uncertainty. Such behaviour can be difficult to avoid, as it ‘feels right’. It also leads to opportunity for those investors able to embrace uncertainty.
4. Oppose consensus
To stand-alone is to feel vulnerable. From a psychological perspective, there is evidence that as humans we seek social validation to justify our decision-making, and we are most receptive to information that confirms and reinforces our existing beliefs. A crude but powerful example of this behaviour is provided by a 1960s ‘sky-gazing’ experiment. In this experiment, a man stopped on a busy NewYork sidewalk and gazed up to the sky. The intention was to assess the effect on passers-by. Only about 4 per cent of passers-by joined the man in looking up. When the number of initial planted up-lookers was increased to five men looking up at nothing, 18 per cent of pedestrians joined them. With a starting group of 15 sky-gazers, 40 per cent of passers-by stopped and joined them in looking skyward. As Cialdini (2004) explains it: ‘One fundamental way that we decide what to do in a situation is to look to what others are doing or have done there. If many individuals have decided in favour of a particular idea, we are more likely to follow because we perceive the idea to be more correct, more valid.’
When it comes to investment, the influence of social validation can lead investors into trouble. James Montier of Societe Generale and later, GMO, compared the de-trended operating earnings for companies in the S&P 500 Index with aggregate analyst forecasts for those earnings over time. He made two striking observations. Firstly, analysts are exceptionally good at one thing – telling you what has just happened, and extrapolating that into the future. Secondly, they display common behavioural biases such as anchoring and confirmation bias. In other words, they are slow to acknowledge their error, and even then they adjust their forecasts very slowly.
But why does expert consensus tend to be wrong rather than merely random? Several contributing factors can be identified from the earlier discussion. Firstly, career risk can lead analysts to fear being wrong alone. Secondly, professional investors and analysts are subject to the same human decision-making influences as everyone else. Furthermore, for analysts and indeed for all investors, behavioural biases such as anchoring and confirmation bias cause them to be slow to change their minds. For these reasons, consensus opinion tends to overpay for popular investment ideas and underpay for unpopular ideas.
Both Warren Buffett and Howard Marks have noted that, contrary to common perception, the risk of an investment tends to move in the same direction as its price, while the prospective return moves in the opposite direction. From Howard Marks: ‘Risk arises as investor behaviour alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns. And as their psychology strengthens and they become bolder and less worried, investors cease to demand adequate risk premiums. The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.’
Consensus opinion tends to perceive risk as lower when prices are higher, and risk as higher when prices are lower. Opposing consensus can be psychologically challenging and feels uncomfortable to many investors. The relationship between prospective return, risk, and the popularity of an investment can be counterintuitive. Ironically, it is the unpopular and uncomfortable that makes contrarian investing a rewarding and sustainable strategy.
Dr Simon Marais is the Managing Director, Portfolio Manager and Head of the Allan Gray Australia team. Before setting up Allan Gray in Australia, Simon spent 11 years with Allan Gray Pty Ltd in South Africa, of which 4 years was in the role of chief investment officer and executive chairman. He retains the role of non-executive chairman of Allan Gray in South Africa. In 2002, Simon joined the Orbis Group where he headed Orbis’ research investment team in London, before permanently relocating to Sydney. Since then he has continued to develop the business that was renamed Allan Gray, on 2 April 2012.
Prior to joining Allan Gray Pty Ltd in South Africa, Simon conducted research in theoretical physics at Cambridge. He holds a Master of Science (Stellenbosch), Doctor of Philosophy (Cambridge), and is a CFA Charterholder.