December 2016 | Lumenary Investment Management

Beware of the one-trick pony

Posted on December 21, 2016May 14, 2018 by Lawrence Lam

Trending companies often have high short term growth potential but limited long term prospects. Distinguishing these businesses from those with increasing long term “staying” power is how we produce long term returns.

To produce long term returns, start by avoiding big investment mistakes

The key objective for an investor is to make money through investment decisions that result in gains over the long term. To achieve this, an investor must first not lose money, but then also ensure that the good decisions outweigh the inevitable mistakes. We have found that good returns come to us when we first focus on avoiding big mistakes, rather than focusing on making big gains. Our defensive approach and focus on risk minimisation, we believe, shifts the investment odds in our favour. It means that we will not participate in fads and trends, and it means that we may pass the opportunity to invest in the “once-in-a-lifetime” companies, but it also guarantees that we have a greater chance of producing higher than average returns over the long run.

As we have observed recently with Bellamy’s (ASX: BAL), and overseas stocks such as Crocs Inc. (Nasdaq: CROX), companies can initially appear to grow at a rapid rate but soon peter out as they are unable to consistently perform over the long term whether it be due to change in consumer sentiment towards their products, regulatory change or erosion due to competition. These “flash-in-the-pan” companies are bad investments can lead to significant loss of capital.

Distinguishing between the sprinters and the stayers

Avoiding one-trick ponies can be hard if the investment focus is on maximising returns. In the chase for superior returns, it is tempting to buy into the hype and to invest ahead of the pack to catch the wave before the rest of the market. These pundits often use projections and assumptions around growth potential to justify the decision to buy into the stock. It is possible that these investments turn out to be the next Google (Nasdaq: GOOG), however we would argue that this is a risky approach. The probability that these investments turn out to be next Google is low and we prefer to avoid these investments all together. Even if the initial investment thesis for that company is proven correct, the possibility of sustained long term growth, we have observed, is rare.

Instead, we maintain a defensive approach to stock investing – we err on capital preservation rather than profit maximisation. We prefer to seek out businesses with proven long-term track records of success and we do not trust our own assumptions enough to rely on them. We have found that this approach minimises our chance of making big mistakes and losing significant amounts of money. It also has the pleasant effect of producing solid returns over the long run.

Do we have as much foresight as we think?

Posted on December 15, 2016May 14, 2018 by Lawrence Lam

Human nature makes us susceptible to biases when we make decisions. One such bias is the overconfidence bias, where investors have the potential to overestimate their ability to predict investment outcomes.

Our investing approach is about minimising the potential for bad investment decisions. To minimise the potential for overconfidence, we separate facts from perception by not focusing on forecasts, projections, or trends. We prefer to spend our time focusing on objective data based on today’s latest information.

A good investor knows they don’t know it all

Coming from an investment banking career, it is common to observe an abundance of self-confidence and conviction being portrayed by individuals in the industry. The certainty that is displayed in arriving at a decision often does not correspond with the level of available facts upon which a decision is made. Decisions are made quickly based on a significant body of subjective information and “gut feel”. Importantly, the overconfidence blinds these individuals – they are unconscious to the nature of their overconfidence. Nobel prize-winning Daniel Kahneman has written an excellent article on this topic: http://www.nytimes.com/2011/10/23/magazine/dont-blink-the-hazards-of-confidence.html?pagewanted=all&_r=0. For investment bankers and other professionals that provide advice, this trait is favourable, as the client perceives an experienced, confident advisor with the conviction they so require.

However, advisors are distinctly different to investors, and to investors, this overconfidence is harmful.

Advisors have no money at stake – they are selling their knowledge and expertise to their clients. In contrast, investors have everything at stake. There are no prizes for investors who reach conclusions quickly based on subjective information. Investors are rewarded for being right, rather than being hasty. From our experience (more precisely, bad decisions) we know for a fact that we don’t know it all. During our decision-making process, we often find ourselves focusing on how we could be wrong rather than why our logic is correct.

How we balance the conviction required to invest whilst being aware of overconfidence bias – objective investing

As an investor, knowing that you don’t know it all can zap us of the very confidence required to reach an investment decision, so it is necessary to find a decision-making process that straddles the fine line between too much self-doubt and too much overconfidence. For us, we tread this fine line by minimising the potential for errors in judgement made through assumptions. Our investment analysis minimises the use of forecasting and favours the use of objective information. By maximising the use of factual data and minimising our own subjectivity, we know our own biases are minimised and our decisions are made objectively. This provides us with a solid foundation of confidence in our investment decision.

In our view, no one is able to predict the future consistently. Moreover, as an investor, attempting to predict the future is fraught with risk. Not only does one need to be correct in the magnitude of their forecast, but the Achilles heel for most investors engaged in the predictive arts, is timing. Even if one is correct at foreseeing the change in direction of a particular sector or company, it is near-impossible to pin point exactly when this change will occur. Investment performance is dependent on when returns are realised.

We have found that our time is better spent focusing on analysing the facts at hand, rather than estimating projections. Our considered investment approach is slow, but once we have considered all the facts and have reached a conclusion, we invest with conviction knowing that our process has minimised the potential for overconfidence.

Why founder-led companies outperform

Posted on December 13, 2016May 14, 2018 by Lawrence Lam

Companies where the founder still owns a large proportion of the business and is involved in managerial decisions consistently produce 4% to 10% p.a more returns than other companies.

However not all of these companies are worth investing in, but we begin our search within these companies – it gives us confidence that we are fishing in a quality pond.

The founder-ownership phenomenon

Founder-ownership, CEO-ownership, management-ownership, inside-ownership. These are all terms used to describe a similar concept – where the people in charge of a company have a vested interest to see it succeed because they own a significant portion of it. There is no shortage of research highlighting this phenomenon – some of these have been attached below. On average, the research indicates that companies with heart outperform other companies by 4% to 10% per annum.

We like this trait a lot. So much so, that we have termed it ‘heart’. It is an intangible quality that drives a business and provides a source of self-motivation for the long term. In sporting terms, heart is what motivates an athlete to put in that extra effort during off-season, with the resultant hard work giving them significant year-on-year improvement. Athlete’s with heart train with intensity and often play at a level beyond their natural physical talents. Fame or attention does not distract them. They simply love their craft and drive themselves to constant improvement. Importantly, these athletes demonstrate objective improvement over the long term. For the NBA supporters, the player that most embodies the principle of heart in the current era is Kawhi Leonard. Kawhi has sustained statistical improvement since becoming a professional 6 years ago and is renowned for his quiet excellence. A business with demonstrated sustained improvement over the long term is a great investment.

Short term management incentive structures aim to replicate this sense of ownership in management, but often fall short. Instead, they only reinforce a short term focus and incentivise management to keep one eye on their stock option vesting dates – they do not promote long term sustainable business growth.

So why don’t we just find all of these companies and invest in them?

Given that the market knows about the founder-ownership phenomenon, why then does it continue to persist? The answer is that not all companies with heart succeed. In our view, it takes more than heart, which is why we start, not finish, our search here. It would be a risky strategy to simply invest in all companies with high insider-ownership.

It is not hard to search for companies with high founder-ownership. The practical challenge is to seek out those businesses that have heart and a competitive edge. We focus our efforts on seeking out these companies with a demonstrated objective track record of performing. Then we buy them at the right price.

Sources:

Stanford Graduate School of Business research on the behavioural changes arising from inside-ownership:

https://www.gsb.stanford.edu/sites/gsb/files/publication-pdf/cgri-quick-guide-09-equity-ownership_0.pdf

Journal of Finance article analysing 22 years of data in the US markets. This research indicates outperformance of 4% to 10% per annum.

https://www.houseoffinance.se/wp-content/uploads/2016/05/executivesummaryU.pdf

You are an inadvertent investor

Posted on December 12, 2016May 14, 2018 by Lawrence Lam

Investing is not an optional activity – we are currently all investors, whether intentionally or inadvertently.

Given that investing is not an optional activity, we need to be aware of our investments and what implications these (intentional / inadvertent) decisions will have on our future.

Regardless of investment goals, investing should be, at the very least, a defence against inflation.

Investing is not an optional activity

Constant updates on financial news, information and statistics fill our newspapers, TVs and personal devices every day. These updates provide us with very detailed information regarding aspects of the economy that may not affect our everyday lives. So why is this information so important that it needs to be on the daily news? The answer, I argue, is that we are currently all investors, whether we choose to be or not. And this news is relevant to all of us whether we like it or not.

Most of us have a bank account and that bank account will contain some money. The money we have that bank account will serve a purpose in our lives. For example, we may be saving for a home, we may be purchasing goods with the money, we may be using it to pay off our debts, or we may just be saving the money as a buffer against unforeseen circumstances. Ultimately, we want this money to serve a purpose for us. We unconsciously make two choices:

1. spend the money now; or

2. keep the money for use later.

If we choose to spend the money now, we have less to spend in the future. In economic jargon, this is called an intertemporal choice. [If you’re more interested in this topic, the Chicago Booth School of Business has published an interesting paper here: http://faculty.chicagobooth.edu/richard.thaler/research/pdf/intertemporal%20choice.pdf]. For the majority of us, we will spend some money now, and keep some for later.

Of the proportion we keep, regardless of whether we make a conscious decision regarding where to keep the money, we will make an investment decision. Even if we choose to do nothing and keep the money in our bank account, we have already unconsciously decided to keep the money as cash. We have invested the money in a bank deposit.

As long as we have savings, we will be making investment decisions, so we are already investors. And as long as we are investors, we should be, at the very least, aware of our choices and what impact these choices will have on our future.

Implications of our choices on our future

Each type of investment has its risks and rewards. Over the short term, we may be more concerned about risks rather than returns. For example, if we anticipate an upcoming expenditure, we will be more inclined to set that money aside in a bank deposit until such time it is required so that the amount is kept safe. The implication of this decision is that a bank deposit typically has a low rate of return compared to other investment options. Over the short term, we would rather preserve our money than take excessive risk, so it is understandable that we may choose to forgo a higher rate of return in favour of preserving our money.

However, the implications change significantly if we adopt a longer-term view. I argue that it is necessary to take risk in our investments over the long term in order to preserve wealth. It is not a choice. The eroding waves of inflation make it unwise to keep all our money in a bank deposit.

Investment as defence against inflation

Over the past 10 years, the price of goods and services in Australia has risen at an annual rate of 2.4% per annum (http://www.rba.gov.au/calculator/annualDecimal.html). In other words, a $100 item in 2006, would now cost us $127 in 2016. If our income remained unchanged over the past 10 years, our ability to purchase goods would have decreased by 27%. The rising cost of goods and services forces us to keep up, otherwise our wealth is eroded over the long term.

Over the long run, term deposits average a 5% to 7% rate of return, providing us with reasonable protection from inflation. Risk is low, but returns are equally low. Some argue that term deposits are safe investments over the long term. I would agree, but I would add that shares are equally low risk of over a long-term horizon. The chart provided by Fidelity confirms that the Australian ASX 200 index has always appreciated over any 6-year period since 1986. See the chart here: http://www.fidelity.com.au/fidelityP2/?LinkServID=B91D14A6-B125-E8DC-BB83AAD60C35BC5A. For no additional downside risk over a 6-year period, shares have generated a return of 9.5% per annum.

With current bank deposits returning 2% to 3%, in my view, it is not an option, but a necessity, to look for investments beyond bank deposits. Investments with the ability to increase along with inflation are preferred instruments for preserving long-term wealth. Whether you are aware or not, we are already running in an investing marathon against the constant headwinds of inflation.

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