The Art of Selling

When we think about investing, we always think about buying. We spend enormous amounts of time forecasting the future, distilling vast stores of information into one single click of a green button. But what is commonly overlooked, is the other side of the equation – selling. It remains the poor cousin of buying, yet it shouldn’t be. Selling is as important to investing as braking is to driving. Selling at the right time is just as important as timing on the entry. Yet all too often, investors only know the accelerator and gloss over the analytical framework of selling. In doing so, they give up much of the hard work they have put in to establish the buy thesis.

In this publication I will share my insights from the perspective of a global equities investor who has made misjudgements when selling and what I’ve learned from the mistakes of others and my own.

Why are institutional investors so bad at selling?

It may surprise you to know institutional investors do not have an edge when it comes to selling. Recent researchers[1] studied the outcomes of selling decisions and determined there was substantial underperformance over the long-term. So bad were the selling decisions they even failed to beat a random selling strategy. These weren’t retail investors. The study looked at portfolio managers with an average USD $600 million size. The outcome? They still failed to outperform a simple randomised strategy.

But why are institutions so bad at selling?

Poor selling hurts returns more than you think

Without an analytical framework for selling, investors use mental shortcuts which are susceptible to behavioural biases and lead to inconsistent results. Poor selling can hurt you in two ways. First, you can sell out of a great company too early. The seed of a Californian redwood tree is only a tiny speck yet it has great potential beyond its appearance. Dispose of those seeds and you end up missing out on a giant.

Second, a weakness in your selling process can lead to prolonging a losing investment far too long. Our cognitive biases can shroud our judgement. We can become committed to a previous decision and fail to see how changing circumstances no longer make an investment worthy of our portfolios.

The psychology of selling

Inspecting my own game, I came to realise the importance of a strong short game to complement my long game. By ‘short’ I mean selling stocks you own, not short selling (which is selling what you don’t own). Most fund managers only focus on their long game and disregard the short (I suspect this is also true of their golf). The research[2] supports this. Professional investors are able to outperform through stock selection and buying, but many underperform when it comes to selling decisions. 

But why? Buying and selling are simply two sides of the same coin. If one can make good buying decisions, why does it differ so much when it comes to selling?

Use heuristics with caution

Recall earlier I introduced the term ‘mental shortcuts’. In psychology, these are known as heuristics. They’re good for simple decision making, but detrimental when it comes to complex analysis required in investing. Without a system of thought when selling, we gravitate back towards a structureless approach. And this is where it can go wrong for many investors. Even at the institutional level, cognitive biases creep in. Research found the most common being:

  • The disposition effect: a reluctance towards selling losers, and inclination to selling winners.
  • Overconfidence: assuming you will make the right decision to sell without any factual analysis.
  • Narrow bracketing: looking at decisions in isolation without consideration for the broader picture. Analysts who focus on one geographic or sector are most susceptible to this.

This makes sense. Most institutional investors spend less time thinking about their selling framework, they are measured for their efforts in buying. Incentives are centred around investment prowess, not divestment skill. I’ve written previously about how enterprising investors can outmanoeuvre institutional investors here.

Easy come, easy go

From my own experience, I deploy more capital to those investments that I have greater conviction in. The greater weighting reflects my analysis and the velocity which I think returns can be made. This conviction when entering a stock also translates to better selling performance on exit. Another takeaway from the study shows poor selling decisions tie closely with low conviction investing. Just think about those stocks representing the smallest proportion of your portfolio. These are the stocks you are most likely to make bad sell decisions with.

Knee-jerks that hurt

One of the main reasons institutional investors make bad selling decisions is because they react to price movements. All the fundamental analysis done when deciding to buy is not mirrored when they sell. Instead, sell decisions are either automatically triggered via stop losses or to capture recent gains. Either way, basing selling decisions purely on price is what leads to underperformance. To counter a pure price focus, the questions investors should focus on are:

Have business prospects fundamentally changed for the future?

Are customers migrating away from this industry?

Does the company still retain its competitive edge?

It’s that time of year

Following closely behind automated selling strategies are the financial calendar trades which occur when professional fund managers decide to sell for no other reason than to realise taxable losses or crystalise their gains as they massage their financial year end results. Annual bonuses drive selling decisions which are proven to underperform in the long-term. From the portfolio manager’s perspective, it may not matter if they are rewarded for these decisions so long as they achieve their end of financial year KPIs.

Knowing these weaknesses is one thing, mitigating them is another. It is only once these issues become known that addressing them becomes possible.

Incentives that create value

The single hardest and simplest correction for most investors is to align your long-term incentives with your selling strategy. If your investment strategy is long-term and you want to compound your investments, then set up a framework that rewards careful, fundamental analysis before selling. I’ve written about this previously here. The same questions when buying should be applied to selling. Here is where private investors have an in-built advantage over institutions – they innately possess the flexibility and natural incentive to perform over the long-term; ignore the arbitrary financial year end distractions and focus on the real fundamentals.

Institutional managers need to think as if they are the largest investor in their fund.

Investing with conviction matters

Dipping toes in waters is not the optimal way to invest. Concentration leads to outperformance as it encourages deeper analysis. Nothing like a big investment to ward off capriciousness. The benefit isn’t only on the buy side. The research shows selling decisions benefit too when concentration is higher. Invest mindfully and with meaning. Underperformance happens when you’re selling out of a stock you were never that convinced with in the beginning. Easy come, easy go, but you will pay for it when you sell.

Stress and other suboptimal influences

Have business prospects fundamentally changed for the future?

Are customers migrating away from this industry?

Does the company still retain its competitive edge?

The answers to these questions will inform whether you hold or sell.

But as we have seen recently, when you’re facing a 30-40% drop in prices, the stomach will take over the mind. Stress sets in, sometimes even panic. This pressure is even greater for institutions who have to report back to thousands of clients. They become price-reactionary. Heuristics to invade the decision-making process when time is pressured. Evidence points to the most severe underperformance on sales coming after extreme price movements. Institutional investors are susceptible to mental shortcuts as they tend to use stop-losses, automatic rebalancing to benchmark weighting, and auto profit-taking triggers to simplify sell decisions.

Sell because of changes in business prospects, not because of stock price movements, even if you’re under extreme market pressure.

How to use feedback

Institutions spend less time analysing the selling decision. They will meticulously track buying decisions, but they rarely analyse how selling decisions went. A technique I employ to improve selling decisions is to elucidate myself with iterative feedback. Track the results of selling decisions just as you would with buying decisions. Each iteration of feedback informs how a sell decision can be improved for next time. Without it, investors are blind to their own mistakes.

The dangers of commitment bias

Cognitive biases cloud our judgement and none are worse than our feeling of commitment that encourages us to hold onto investments longer than we should. The sell decision is based on logic and business prospects in the future. Waiting for an eventual turnaround is useless if a company’s customer base has fundamentally changed, or if its competitive advantages have been eroded by competition. I have scars to show for this misjudgement. Under-selling can be just as detrimental as over-selling.

The evolution of selling

The evolution of any investor understandably begins with focusing on buying, but sophisticated investors that truly understand when and how to sell, transcend into becoming adaptive investors able to compound wealth in any market condition. Adaptive capital is where you ride each wave as it presents itself. To do that, you need to be skillful at braking, not just accelerating.

Happy compounding.

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that invests in the best founder-led companies in the world. We scour the world looking for unique, overlooked companies in markets and industries on the edge of greatness. We are a different type of global fund – for more articles and information about us, visit https://lumenaryinvest.com

Disclaimer

The material in this article is general information only and does not consider any individual’s investment objectives. All stocks mentioned have been used for illustrative purposes only and do not represent any buy or sell recommendations.


[1] Akepanidtaworn, Klakow and Di Mascio, Rick and Imas, Alex and Schmidt, Lawrence, Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors (September 2019). Available at SSRN: https://ssrn.com/abstract=3301277 or http://dx.doi.org/10.2139/ssrn.3301277

[2] ibid

Now is the time to beat the fundies

This article was first published in Livewire Markets, 2 April 2020: https://www.livewiremarkets.com/wires/now-is-the-time-to-beat-the-fundies

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Plenty of commentary has already been written about the economic impact of COVID-19. Whilst these opinions make for interesting reading and dinner table debate, they distract investors from the main issue at hand. How can enterprising investors capitalise on the tangible advantage they have over large institutional investors right now? How should long-term investors allocate capital in this environment? What can you do now to prepare for the inevitable rebound?

Current Sentiments – am I catching a falling knife?

Some investors are cautious about the current environment. Is there worse to come? Am I catching a falling knife?

The fact is most stock prices have been falling. They are all falling knives. Catch the best knife and you’ll be rewarded when this uncertainty clears. Stock prices will be volatile over the coming months. It is highly likely we haven’t seen the worst. The question shouldn’t be ‘am I catching a falling knife?’, it should instead be ‘which is the sharpest knife to catch?’.

Structural constraints for some, inherent advantage for others

Large institutional investors have in-built risk triggers that have been set in motion by the market pullback. Rather than making rational decisions about the merits of the actual underlying investments they hold, hardcoded rules force large institutional investors to divest during this current pandemic. For example, the government’s $10,000 tax-free superannuation withdrawals has forced super funds to liquidate investments to maintain appropriate cash buffers for redemptions, even as their portfolios continue to be devalued. The pressure to divest is strong. Clients are redeeming and this places pressure on large funds to crystalise their losses and hold cash during this time. The selldown leads to more selling and an even sharper self-fulfilling pullback.

Companies I have been stalking for years have been written down significantly, some by more than one third. These remain sound companies with strong balance sheets and moats, yet their valuations are suggesting permanent irreparable damage to their businesses. This is simply irrational.

For enterprising investors without institutional constraints, this is a once-in-decade opportunity. Sure, there will be volatility ahead, but capital is being pulled with no sensible consideration to the actual underlying value of companies. Now is when you can exploit the structural constraints faced by large institutional fund managers.

Instead of the usual buy/sell stock recommendation, I’ll share a framework for how you can strategically position your portfolio during this period in preparation for when institutional investors come flooding back and you can get in ahead of the rebound. So here’s how you might do exactly that.

Read the play – cash allocation

Of course to fully capture the discounted pricing at the moment, investors should have enough capital to deploy for these opportunities that arise. I’ve written previously about gauging the investment climate and how to utilise trends to your advantage. Unlike large fund managers, you are not hamstrung by requirements to be fully invested. The absolute freedom to control the level of cash in your portfolio is a key advantage. To realise this, preparation should have been done to take stock of the prevailing market environment. The low interest rate environment in recent years has lulled investors into holding less cash and encouraged them to seek out more adventurous investment opportunities. Besides a buying opportunity in late 2018, enterprising investors who held higher than usual levels of cash are now being rewarded with the opportunity to invest in quality companies at very reasonable prices.

For Lumenary Investment Management, we came into 2020 with a quarter of our fund held as cash. Many thought we were being too conservative, but my view was the fundamentals justified such an approach. The dry powder is now coming in handy.

But for investors who have not been able to fully prepare coming into this correction, it is not too late. You can still maximise your chances in anticipation of the next phase, and the inevitable rebound.

The first question you need to ask

‘Will this company survive the economic hiatus?’. This is the first question investors must address. The answer? Look at the cash flow statement. Break it down into controllable and non-controllable items.

Which cash flows must be paid and which ones can management control?

What short and long term liabilities need to be supported?

How much cash will a dividend suspension save the company?

Are there any debt facilities available immediately to cushion cash flows?

Bank analysts will term this as consideration of a company’s liquidity position.

Never has the cash flow statement and balance sheet been so in fashion.

Assuming you’re comfortable with the prospects of survival, only then should investors draw their attention to the post-COVID-19 world.

A simple (maybe controversial?) systematic risk reduction strategy

The central component to how I systematically reduce risk is by focusing on founder-led companies.

Founders are very attached to their companies, they reap the economic and reputational reward (and risks) of a well-run company. This is exactly why we like investing in them. In extreme times, knowing that we are invested alongside a founder who has just as much to gain (if not more), gives us a strong foundation of confidence. We are also very fond of the governance structure that typically allows for long-term continuity and a focus on compound growth rather than individualised short-term bonus incentives. Sure, pundits will point to plenty of bad founders (we’re all thinking of Adam Neumann of WeWork here) and no doubt these exist, but that is why being a founder-led company should only be the start of the search. There are still plenty of other criteria that must be addressed before you should consider a company worthy of investment.

Look for income deferral, not permanent loss

One thing is certain – almost all companies will see a fall in revenues. This shouldn’t be a surprise to investors. Instead, look for companies that have a product or service that their customers will come flooding back to when business resumes. Just think about that car you’re set on buying. You’ll buy it. It’s simply a matter of when. Even if you can’t buy it now, you’ll wait until after the lockdown. Look for companies where income is deferred, not permanently lost.

We have recently invested in a biomedical company that is one of only five global suppliers to the world’s fertility market. Many clinics are shut for now, but the baby-making business and human desire to have children is most certainly only in hibernation. Expect it to resume booming once the lockdown is over.

To further maximise your chances of success, investors should be prepared for unknown unknowns.

Is the house in order, or are they living on borrowed time?

Look for companies with minimal debt. Better still, look for zero-debt companies like I do. Why? For starters you can be sure they cannot go bankrupt. But secondly, those with minimal or zero debt will be cushioned against impacts by the still unknown market effects yet to play out.

We have yet to see the flow-on effects of the extreme government stimulus packages seen globally. How these packages are funded is not yet clear, but expect the credit quality of many governments to be put under pressure. This may have further impacts on broader credit markets and corporate debt. For this reason, maintain a level of appropriate caution.

We have recently entered into a position holding one of Europe’s largest live entertainment organisers. Acquiring their dominant market position and multi-channel distribution network at a 40% discount to the price at the start of this year is a no-brainer to us. And yes, it’s founder-led, has expected permanent income and zero debt.

Closing remarks

Catch the falling knife and catch the best one.

Institutions are under pressure to divest. The advantage now sits squarely with enterprising investors who are able to prepare for the stock market’s next phase.

Read the medical predictions if you want to contribute to the dinner table debate, but know it won’t help a great deal when it comes to making investment decisions. Instead, the cash flow statement and balance sheet is where you will find the clues you need.

If you’re sure the company can survive, then check the income is deferred, not lost, and be prepared for further volatility and uncertainty.

The opportunity to acquire quality companies at reasonable prices doesn’t come very often – allocate your capital wisely and you’ll profit when the lagging institutional investors follow you back into the market.

Happy compounding.

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. We are a different type of global fund – for more articles and information about us, visit www.lumenaryinvest.com

Lawrence Lam
Managing Director & Founder

How to determine if the trend is your friend

This article was first published in Livewire Markets, 18 September 2019: https://www.livewiremarkets.com/wires/is-the-trend-really-your-friend

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At a recent lunch with another fund manager, I found myself engaged in a discussion about the state of the current market, ‘From your perspective, are you seeing many good opportunities?’ I asked.

‘I’m seeing good companies, but prices are toppy,’ he said, wincing before continuing. ‘More than I’d like to pay. But we’ve recently deployed more anyway.’ He shrugged his shoulders, ‘Momentum in the market is strong – the fed is decreasing rates. Despite the high prices, we wouldn’t want to miss this momentum.’

I nodded as we both acknowledged this unique investment environment of decreasing rates and high stock valuations. Yet stock prices have continued to climb steadily.

Walking back to my office I reflected, and asked myself: ‘Is now a good time to be a momentum investor, or is it time to go against the herd?’

Look at a market cycle to assess how much is left in the tank

Momentum investors have much to gain if the wave of popularity is caught early. However, be the last one to the party and you will be left with all the cleaning up. The real question is: how much more of the wave is left to catch? The solution to this contradiction can be found by understanding the long-term context.

The ratio of a company’s stock price-to-intrinsic value tells us how much the market is willing to pay for the company. It’s a useful measurement of sentiment at one point in time. There’s a clear link between sentiment (the stock price) versus fundamental value (intrinsic value).

But it doesn’t give us the full picture. To understand this contradiction, we need to see how sentiment for the stock has changed over a significant period of time – over entire market cycles. Extend the ratio of stock price-to-intrinsic value over a 15-year horizon and you’ll now gain a multi-dimensional view of just how manic-depressive Mr Market is.

As an example, here is the change in sentiment for the founder-led aerospace electronics company HEICO Corporation.

During the GFC, Mr Market was very pessimistic. He was only willing to pay 1.8x the intrinsic value of HEICO. But alas Mr Market is as fickle as they come. More recently, he has been very bullish. He’s willing to pay 4.8x intrinsic value. A large proportion of the returns have been driven solely by the company’s increasing popularity with investors.

Now we have a better view of the context. Understanding the stock price and intrinsic value over a long time period equips us to answer the following question…

The worst time to join a party

There’s an interesting observation about parties. When do they end?

Answer? They end when the alcohol runs out. Rarely do they end immediately though; good times roll on for a while longer before the sudden realisation hits the sobering crowd.

So when is the worst time to join a party?

As you’re pondering the answer, here is another view of HEICO to illustrate the point.

Although the intrinsic value of HEICO’s business has consistently increased over time, the increase in its price has far outpaced the fundamental growth of the company. HEICO is a solid and growing company, but its impressive performance has been driven primarily by sentiment and price, rather than actual business value. The price-to-intrinsic value ratio shows this.

Risk is heightened when a company’s stock price outpaces its intrinsic value for significant periods of time. As crazy as Mr Market is, one thing is certain – his enthusiasm and pessimism never last forever. The gravitational pull of a company’s fundamental value is unrelenting.

The best time to join a party is when there’s plenty of alcohol and not too many people. But tread carefully when the crowd is pumping and booze is running low. Whilst the fun may continue for a while longer yet, the risk of an abrupt ending is heightened.

A ‘reasonable’ price

Pure momentum investing focuses predominantly on the historical price movement and pays little attention to actual fundamental value. But if you want to understand if a trend is justified, the fundamentals are critical.

Armed with this insight, we can make a judgement call on what a ‘reasonable’ price would be and whether we should join the party. Some sectors run hot. Today, technology is a classic example. But a strong trend shouldn’t be a deterrent. Prices may seem exorbitant, but in the context of the company’s historical sentiment, sometimes the high price is worth paying. What may seem expensive on an absolute basis may be reasonable in the context of history. For example, the price-to-intrinsic value of Facebook was high on an absolute basis in late 2018, but was reasonable when compared to its history. It has proven to be a good entry point so far.

But there’s more for enterprising investors – the picture is still not yet complete.

A deeper level of analysis

Competition

You may have noticed my focus on individual company analysis rather than broad-based economic generalisations. We are buying slices of companies after all. Whilst we can understand the sentiment in our target company, it is also important to have context across other comparable companies. The same price-to-intrinsic value historical ratio across a few companies will give us a sense of sentiment across the sector. We’ll be able to see if there are any other reasonably priced companies.

Potential growth

So far the focus has been on gaining historical context. Sometimes the momentum is justified if there are tangible growth prospects. In other words, intrinsic value is expected to grow significantly with price. In those situations, the trend may be your friend. For those that heard me speak at the AIA National Conference, I outlined my framework to assess the potential growth of a company.

Intrinsic value

Speculators focus on stock price movements only. Investors focus on the underlying true worth of a company.

As Warren Buffett says “Price is what you pay, value is what you get”.

The fundamentals of a company’s value is reflected in its Intrinsic value. Importantly, in determining a company’s intrinsic value, I’ve stripped out accounting distortions that may hide a company’s true worth.

So… Is the trend your friend?

If the fundamentals of a company are sound and the price is reasonable in the context of its history and other competitors, then the trend may indeed be an ally. Ride the wave and enjoy the party.

Price and intrinsic value may deviate for many years but price will eventually move towards intrinsic value over the long-term. Seeing the full picture is key to capturing sensible opportunities. In every party, everyone sobers eventually.

Happy compounding.

Note: HEICO has been used here as an example only, this article is not a buy or sell recommendation for any of the stocks listed.

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. We are a different type of global fund – for more articles and information about us, visit www.lumenaryinvest.com

Lawrence Lam
Managing Director & Founder

Investing like Howard Marks during the GFC

This article was first published in Livewire, 29 April 2019: https://www.livewiremarkets.com/wires/investing-like-howard-marks-during-the-gfc
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Great investors have an uncanny ability to find attractive investment opportunities in any market. During the depths of the GFC when fear of the unknown paralysed most investors, Howard Marks, co-founder of Oaktree Capital Management, invested an average of USD $625 million per week during 2008-2009. A shrewd (and profitable) decision in retrospect, it was far from an easy decision at the time. Headlines from the Wall Street Journal read ‘Worst Crisis Since ‘30’s, With No End Yet in Sight’. Yet through those dark days, investors that found opportunity in that moment have been rewarded in multiples.

The climate today is one of uncertainty and hesitation. Market commentators have been referring to the current cycle as ‘it’s currently three quarter time’, implying we are 75% through the market cycle, with one quarter remaining before an impending downturn awaits. I don’t ascribe to this view. The issues with this mindset are two-fold. First, investing is not a football game – there is no guarantee of four precise quarters. Second, profitable companies exist in all market cycles, even in recessions. In fact, exceptional companies expand market share from competitors during downturns. Adversity is the friend of great companies but the enemy of the mediocre. In investing, many players can continue kicking goals even after the final siren.

The opportunity to invest like the 2008 Howard Marks exists today. As Mario Gabelli (founder of GAMCO Investors) says ‘If you don’t look, you won’t find’. So how does one find the hidden opportunities that others are blind to?

As Mario Gabelli (founder of GAMCO Investors) says ‘If you don’t look, you won’t find’.

Trade wars, Brexits, slowdowns and other red herrings

To find the diamond in the rough, you must first be open to looking for them. It is a great temptation to many investors to abandon the search for opportunity when faced with today’s latest headlines. But the more investors that abandon the search, the greater the reward for those that continue. The only relevance that headlines might have, is their effect on pricing, not on the value of the opportunity itself.

I’ll illustrate what I mean by way of example. We’re an investor in an advanced manufacturer domiciled in Hong Kong with a market capitalisation of USD $500m. On the face of it, an advanced manufacturer with plants in China and customers in the US doesn’t have a bright outlook. The ongoing US-China trade war would be a concern to most investors. However for opportunistic investors, the hidden opportunities present themselves when you look beyond the macroeconomic red herrings and delve deeper into actual business-related facts. After all, we are investing in companies, not economies.

This lesson was reinforced for me when I spoke to to the CFO of the company. It turns out the newly-imposed 25% tariff only applied to 7% of total revenues. Actual business impact was minimal. In addition, he told me one of their largest customers, Google, had instructed them to ship their finished products to Taiwan instead of the US. By doing this, Google would be able to bypass the impact of the tariff. Importantly, it is easier for Google to change the delivery supplier than to change the manufacturing supplier.

So what does this example highlight? We invest in businesses. Not economies. Therefore investment decisions should be based on business-related facts, not high-level economic facts. You won’t find the hidden opportunities if you’re distracted by the red herrings. For most investors who choose to wait until the macroeconomic dust settles, the hidden opportunities won’t exist anymore.

But don’t complain the next time you hear someone provide a macroeconomic reason to justify their decisions. It is their approach that provides us with the mispricing and the very existence of that limited edition piece that no one even knew about.

Mining for gems

Silent opportunities can often be found in the detail that others overlook or don’t take the time to see. This was one of the free kicks our fund benefited from when we invested in a Belgium-based weaving loom manufacturer with a market capitalisation of EUR $1.5 billion. On a standalone basis, I was already more than satisfied with the success of the weaving loom business. Tick. The company is led by a motivated and intelligent entrepreneur. Second tick. This company also owns 38% of a EUR $1.5 billion chemicals company. On my continued mining, I discovered that this 38% holding was recorded at book value. This is a crucial detail. It means that the assets of the weaving loom manufacturer reflect the price it paid when it acquired the chemicals company years ago, not the current market value. It is akin to buying a house, then discovering upon moving in there is treasure hidden in the backyard. Triple tick. Following further investigations, I was pleased that the hidden treasure was real and it was undervalued by the vendor. A bonus sweetener for an already quality house.

But don’t complain the next time you hear someone provide a macroeconomic reason to justify their decisions. It is their approach that provides us with the mispricing and the very existence of that limited edition piece that no one even knew about.

Closing remarks

Rare stones exist everywhere. In order to find them, investors must ignore the red herrings and remain open minded even when situations seem most dire. Opportunities are most plentiful during uncertain markets but if you wait until the dust settles, everyone is looking at the same thing with 20/20 vision.

Adversity is the friend of quality companies and an enemy of the mediocre. The experiences I’ve seen demonstrate why it pays to keep searching for facts that relate to the company, not the economy. The more you focus and seek out opportunities, the greater the odds stack in your favour.

Happy compounding.

About us

Specialists in uncovering the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. Our portfolio is made up of stocks that sit outside typical index constituents.

Lawrence Lam
Managing Director & Founder

Data: a different way to discover quality companies

A shortened version of this article was first published in Equity magazine 23 Apr 2019 issue: https://www.australianshareholders.com.au/equity
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With the abundance of data in this digital age, more than ever, private investors have the opportunity to stay ahead of the pack and find rewarding investment opportunities. But it’s not just about access to data.  It’s about being clever and filtering for investment opportunities that others don’t see. In this article I’ll highlight a different approach to generating quality investment ideas by applying a different lens. I’ll also share some common pitfalls I’ve observed and experienced myself.

Start broad

You generally don’t attend an auction and buy a house just like that without having first looked at a variety of neighbourhoods and inspected multiple properties. Why? Because it’s helpful to have multiple data points to compare and consider. Yet in the investment world with even bigger dollars at stake, many investors have, whether conscious or subconscious, preconceived notions about certain asset classes, sectors and geographies. They prematurely make assumptions that constrict their universe without having first considered the wider world of opportunities. How do you know your favourite bubbly is champagne without trying or at least knowing about prosecco, cava or sekt?

The classic illustration of this is a phenomenon known as home country bias. Australian investors collectively hold 66.5% of their portfolios in Australian shares, yet Australian stocks represent only ~2% of the world’s stock market.[1] The same is true even in the US, where US investors allocate 79% of their portfolios to US markets, which although large, comprises only 51% of the world market.[2] Why is that? There is no plausible objective rationale linked to achieving more favourable investment returns by investing in this way. Other than perhaps fear of the unknown and comfort in the known.

Diagram: Despite the small size of the ASX, home country bias still exists[3]

Digitisation of just about everything has made data commoditised. Many private investors today have the same opportunity as the world’s largest fund managers to access global data. This has neutralised the huge informational advantage that institutional fund managers once had. The abundance of quantitative tools such as Morningstar, broking subscriptions, stock screeners and other filtering tools found online has aided the search process. Many of these tools are free. Though there are of course additional paid resources that investors who mean business should utilise. These include Factset, Capital IQ, Reuters and Bloomberg, some of which we ourselves employ at Lumenary Investment Management.

The lesson? There are a world of investment opportunities that exist if you start your search broadly. Begin with the widest available dataset and minimise the presumptions you make, be it geographies, industries or sectors. Start the dataset of your stock screener by capturing as much of the investable universe as you can, rather than having the inclination to filter opportunities out too early.

Know you will underperform

Assuming you’ve found a suitable data source for yourself as a private investor, how do you discover those hidden investment opportunities that others have missed?

To start, investors need to strive to be above-average. Being above-average means thinking and seeing opportunities differently to the rest of the herd. Which means taking a risk. You’re not going to catch alpha by following the pack.

Even though you may be trawling through the same information, that edge over the consensus comes from analysing it different and not having the same assumptions and consequently, conclusions. This is exactly what will lead you to opportunities others may overlook. But be prepared: being different evidently means performing better than others and potentially worse in certain periods.

Only investors who are comfortable venturing from the flock (and by definition, over-performing and under-performing the market average) should consider the below ways to view the world differently.

All companies are the same

Companies should be seen as vehicles for generating investment returns. It shouldn’t matter where the vehicle is domiciled, or what sector it belongs to. Its job is to get you from A to B the fastest by using the least amount of fuel. The outputs of the vehicle and its efficiency is what matters. Many investors can get sidetracked on proxy data, often industry-specific, when what ultimately matters is the profitability, solvency, efficiency of capital allocation, and growth potential of the company.

Counter-intuitive as it may be, yes, you should be comparing apples with pears and making a decision on which ones tastes better. Why sit there and select the best apple out of the orchard, when overall the pear still comes out on top?

Many investors are indeed too fixated on individualised sector-specific metrics when undertaking their stock analysis. To overcome the risk of missed opportunities, retailers should be compared with technology companies which should be compared with manufacturers which should be compared with pharmaceuticals. The metrics of comparison should be the same: the returns they provide the investor.

Using the same data but applying a different lens

In Moneyball[4], the Oakland A’s baseball team developed a specific statistic termed ‘on-base percentage’ and discovered it to be an excellent predictor of player success. Even though the source data was widely available, no other teams read the data and correlation as Oakland. Same data, but a different way of thinking. This difference in perspective gave the Oakland A’s an edge.

as Warren Buffett says, “You never know who’s swimming naked until the tide goes out.”

The same principle applies to investing. Investors should view timeframe as an important differentiator. Whilst most investors filter for a 3-5 year horizon, applying a longer view in your quantitative tools will give you a different lens. Quality companies come to the fore during adversity and the phonies are found out. A valuable lesson for those investors often caught up in bubbles is to increase the horizon of analysis to cover at least one market cycle (typically 8-12 years). A company may look great in over the short-term, but as Warren Buffett says, “You never know who’s swimming naked until the tide goes out.”. At Lumenary, we analyse companies over a 10+ year horizon to avoid the skinny dippers.

Even after you’ve searched and found quality companies, the process isn’t over – it’s just the start. A lot more work still needs to be done and here are some mistakes I’ve made, and have seen others make.

Caution: the common pitfalls

Rigidity

Stock screeners can help investors automatically filter a large universe, but be mindful that they are very black-and-white. For example, if investors screen for a threshold level of profitability, they may miss opportunities if a great company falls just shy of the required threshold. It’s still a great investment opportunity, but you would have missed it altogether. For this reason, we at Lumenary do not use automatic screens. We prefer to manually review financial data which allows us to exercise flexibility and human judgement. Human judgement is what allows us to consider various data sets for how we want to process and analyse it, rather than having a program form conclusions for us.

Price ignorance

Many US investors in the 1960s and 1970s were burnt when they discovered that quality companies didn’t automatically lead to great returns. Surely investors couldn’t go wrong with quality companies such as General Electric, IBM, Gillette and Xerox? The issue, they found a decade later, was that the Nifty Fifty, as glamorised by institutional investors, were quality companies but purchase price was too high. The mantra ‘growth at any price’, isn’t a solid investment strategy. Even when you’ve found a quality company, the purchase price is still an important driver of future returns.

Diagram: The Nifty Fifty experience showed the importance of not over paying.

Ephemerality

When investors search for companies of high quality, they can become attached to particular metrics. As the Oakland A’s discovered, the profitability of rules-based methods diminishes as they become more popular. As more baseball teams adopted the ‘on-base percentage’, the more it became the average and eventually lost its effectiveness. The lesson for investors? Remaining above-average requires a continuous evolution of search criteria to remain ahead of the pack. Predictive models are successful for a period of time, but no universal rules persist forever. Be flexible and fluid to stay ahead of the pack.

Closing remarks

Data is critical for the search of new investment opportunities. For the enterprising investor seeking to be above-average, it’s critical to see the world with a different lens. Use data differently to develop alternative ways to filter stocks and don’t prematurely hinder your search. Quality companies have proven performance over the long-term, so measure them over a longer horizon, otherwise it becomes hard to differentiate the stayers from the sprinters. And just as you’ve discovered a quality company, remember this is just the start of the process. Much more work remains to then consider its competition, moat, management, business strategies and valuation.

Happy compounding.

About me

Lawrence Lam is the Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach.

Lawrence Lam

References

[1] https://personal.vanguard.com/pdf/ISGGAA.pdf

[2] ibid

[3] https://www.visualcapitalist.com/all-of-the-worlds-stock-exchanges-by-size/

[4]   Hakes, Jahn, K., and Raymond D. Sauer. 2006. “An Economic Evaluation of the Moneyball Hypothesis.” Journal of Economic Perspectives, 20 (3): 173-186.

Mindset of an astute investor

A shortened version of this article was first published in Cuffelinks: https://cuffelinks.com.au/mindset-astute-investor/
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Investing is about understanding businesses and as with all things business-related, nothing is ever clearcut. Businesses are comprised of a set of strategies which have been selected and implemented by management. However no one can guarantee the success of a business strategy – not even management themselves. So what hope does an investor have? In this article I’ll explore the characteristics of a certain type of investor who holds an advantage. I’ve termed them the ‘entrepreneurial investor’.

Business owners think differently

In 1947 Benjamin Graham coined the term the ‘enterprising investor’. He outlined how an edge could be gained by delving deep into the numbers to determine the true underlying value of a business. But that edge is harder and harder to find these days. There are simply less cigar butts and more people looking for a free puff. It’s a tough game if you’re only relying on that strategy.

So if studying the numbers won’t give you an edge, what will?  One of the answers I believe, lies in the saying ‘walking a mile in one’s shoes’. If you’ve ever run a business or grown a business, big or small, you have an edge over those that haven’t.  You are an entrepreneurial investor. You possess an understanding of business that can’t be understood through research alone. As important as the numbers are, they are only the first step of analysis. What’s more important is being able to judge which numbers are important and knowing when to use intuition.

So put yourself in the shoes of a founder – someone focused solely on growing the business over the long term. What truly matters to you and how you operate your business will be drastically different to a fly-in CEO chasing a bonus.

If you haven’t owned a business or run a business, all is not lost. You just need to understand a few principles of how good business owners think, then apply them to your judgement as an investor.

Seeing opportunities when conservative investors don’t

Running and growing a business involves the optimisation of multiple levers – decisions about the best allocation of fixed resources for maximum long term return. If you have been in that position, you will know what constitutes good capital allocation

I’ll illustrate this by way of a real life example of a company we are currently tracking. Consider a dominant furniture retailer going through a transition period. After many years of leading the market, lower consumer sentiment has led to a recent decrease in sales. In addition, customers are increasingly heading online for homewares. Investment analysts have punished the stock for its recent earnings decreases. In response to the evolving market, the founding family and majority shareholder recently appointed a new CEO with a mandate to spend significant resources on a new digital online store. This expenditure has led to an even greater short term cost blow out.

Conservative investors would steer clear of this investment. On the surface it seems like a dinosaur industry set for extinction. Investors would look instead for the ‘safe’ cash cow blue chip that pays a high yield.

However for entrepreneurial investors, this represents a clever investment opportunity. Sentiment is low and the stock has not been this cheap for many years. The significant investment in the online store is a shrewd move by the founders. The direction towards digital distribution has been managed prudently and early results are promising. The once-off investment cost has masked the imminent turnaround. This transition represents a sensible opportunity to take a calculated risk.

Entrepreneurial investors understand that allocation to growth projects is not optional, it is a necessity. Risk is part and parcel of improvement. Improvement is not a choice; if you’re not improving, you’re a sitting duck. What’s most important is that the allocation of capital to this project is thoughtfully considered and prudently managed. In this case, this is a favourable risk/reward tradeoff even though conservative investors may see differently.

Betting on moats, not news

Anyone who’s started their own business venture knows that new initiatives take time. Usually longer than anticipated. Jeff Bezos, one of the world’s most successful founders, outlines his thinking on results – “Today I’m working on a quarter that is going to happen [3 years from now]. Not next quarter. Next quarter for all practical purposes is done already and it has probably been done for a couple of years.”

For most fundies, Bezos’s 3 year time frame is too long. Afterall, a fundie could change careers multiple times in that period. Fundies need to pick up quick results and so they favour a quarter-to-quarter game of news arbitrage. Because this approach is short term, it relies on betting on news announcements, rather than betting on business moats. For investors to truly bet on a business moat, they need to allow ample time for the growth initiative to crystallize. This requires patience and an understanding that initiatives take time to bear fruit.

One such business I visited recently in Japan transformed itself from a printing company into a data provider. They now dominate the Japanese food industry – a slow moat-building process which has taken them 10 years to establish. Initially starting by digitising print data for their customers, they developed software that now owns the pricing data of the Japanese food advertising market. Because the moat has taken so long to build, it is very difficult for competitors to erode.

The most important thing in business

Business owners understand the power of human nature. People, when aligned and motivated, can achieve great things. Drive, heart and nous are the most important things in a business but are instead often overlooked in favour of well-credentialed management teams with little vested interest.

When Warren Buffett took over Berkshire Hathaway, it was a struggling textiles business. Although you wouldn’t have backed the original textile business itself, you would have backed Buffett’s ability to change the core business. Great operators with the right motivation will find a way to navigate through any challenge.

Australian visionaries Roger and Andrew Brown (ARB Corporation), David Teoh (TPG Telecom), Andrew Hansen (Hansen Technologies), Frank Lowy (Westfield), Barry Lambert (Count Financial), and Graeme Wood (Wotif.com) have been the heart and soul behind their companies. These founders have demonstrated an incredible ability to compound shareholder wealth i.e. their own wealth. Those who have invested alongside them have been repaid handsomely. They’ve all demonstrated a shrewd ability to take calculated risks and look for hidden opportunities.

Entrepreneurial investors understand that backing the right people is just has important as backing the right business. To do this sensibly, investors need to ensure there is genuine motivation and desire to further the growth of the business for the long term. For this reason we favour investing in founder-led companies.

Closing remarks

Investors with experience owning and running their own business have an edge over the typical conservative investors. They’ve been in the shoes of management. They know what’s important and they’re comfortable backing the right people with carefully considered strategies. They recognise that business success requires continual improvement and calculated risk-taking.

By drawing on this experience and combining it with financial analysis, they have more strings to their bow than the typical conservative investor. There is no better example of a business owner, entrepreneur and investor than the the world’s greatest entrepreneurial investor himself, Mr Warren Buffett.

Happy compounding.

About me

Lawrence Lam is the Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach.

Lawrence Lam

Our foot is now firmly on the pedal

This article was first published on Livewire Markets
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Having spoken to many investors, the most common misjudgement I’ve observed is binary thinking. That is the tendency to think in black and white. Let me share two stories that illustrate why investors are missing out because of this, and how you can avoid the same pitfalls.

Investing with fifty shades of grey

In 2017 a reporter erroneously quoted Howard Marks, saying ‘Howard Marks says it’s time to get out ’.

Howard Marks denied this quote and responded ‘there are two things I would never say. One is “get out” and two is “it’s time”. I’m never that sure. And I don’t think anybody can be that sure.’

Marks further went on to say ‘It’s not a matter of in or out, today or tomorrow, all of which have so much precision and definiteness to them. But rather, think of it as a speedometer from zero to one hundred.’

Investors commonly oversimplify investment decisions based on market trends. This is fine except when investors react in a binary way. For example, popular current examples include ‘‘tech stocks are tanking, I should get out’, or ‘trade wars will last for a while, I shouldn’t invest in global equities’. Blanket thoughts like these are wealth harming. If your concern with the macroeconomy causes you to react this way, you’ll likely miss opportunities.

The lesson?

Right now general sentiment is negative. Human nature impels us to steer clear of equity markets. But don’t think in black and white. You have the option of adjusting your allocation to cash or stocks to capture today’s sentiment. You don’t need to be fully in or fully out of the market. In the past year, we’ve had our speedometer at 50.

But in the past few months, companies we’ve been stalking for a while have fallen into bargain territory. Our foot is now firmly on the pedal and we’re now cruising at 80, having recently snapped up a few quality buys.

Why you shouldn’t read the news

As humans, we are attracted to extreme statements. They capture our attention. We like them because they simplify how we see the world. They give us a short internal summary which we can easily file away in our memory bank. But the world is complex and investment opportunities are not black and white.

Right now all the economic headlines are negative. But it was only at the start of the year that the market was bullish. Headlines change on a dime. Whilst this makes for entertaining reading, they shouldn’t be used to form investment decisions. Journalists are here to sell papers after all.

Instead, investors should focus on the detail underpinning each company. There are always companies that make money even in the most dire economic environments (example below). Excellent investment decisions are made with a scalpel, not a hammer. It is the perception of a company’s prospects that can change overnight, not the actual prospect itself. Actual prospects often take years to play out. So read the company news section, not the economic headlines.

We’ll use Nike as an example given we’re an investor and I’m very familiar with them. Binary investors relying on economic headlines in 2008-2009 exited equities altogether based on 2009 headlines such as ‘The biggest crash since the 1930’s will take decades to recover’ and other similarly extremist views. Nike’s share price fell 20% and yet earnings were increasing through the GFC.

Investors who studied the company rather than the headlines would have reaped a handsome 400% reward over the ensuing 10 years.

The lesson?

There are successful companies in every country and in every economic environment. You just need to look for them. Be influenced by macroeconomic headlines at your peril.

Closing remarks

Investors can’t be blamed for thinking in extremities given recent news. But relying too much on popular sentiment can lead to missed opportunities. As the herd is withdrawing, quality companies are becoming better value.

For this reason, we are stepping on our accelerator.

If you find yourself following headlines, just keep the following quote in mind:

‘No one goes there nowadays, it’s too crowded’ – Yogi Berra.

This doesn’t just apply to industries and stocks, the sidelines can get overcrowded too. Remember it’s not just about Afterpay, or not Afterpay, Aussie or international. Oceans of quality companies in a range of industries and countries are thriving in today’s economic conditions.

If you believe the news, you won’t look twice.

And if you don’t look, you’ll regret missing the opportunities once this hoo-haa inevitably passes.

Pick up your scalpel, and happy compounding.

Lawrence Lam

Sensibly Predicting the Future

A shortened version of this article was published in Money Management 15 February 2018 issue

 A practical framework for analysing the future prospects of a company, without getting carried away with market sentiment.

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In this article I want to outline a framework for assessing the future prospects of a company. This controlled framework of thinking will maximise the chances of picking great investments. Importantly, it will minimise the chances of getting carried away with overly optimistic or pessimistic opinions and potential misjudgement.

 

It’s essential to form an independent judgement rather than rely on the views of others, otherwise the risk of herd mentality increases. Unlike in the African savannah, staying with the crowd does not guarantee safety in the financial world – in fact history tells us that following the financial herd can be extremely risky.

So whilst I don’t profess to be able to predict the exact future earnings of a company, I do offer a way of thinking which may assist an independent thought process. The end goal is to make sound investment decisions which will hopefully lead to long term profit.

First separate facts from predictions

Donald Rumsfeld once said “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know”

This is not only true in politics, but also in investing. Information about a stock allows us to determine its true value. This information can either be in the form of facts or predictions. Facts are proven pieces of information and should form a core component of determining value, whereas predictions are not guaranteed and come at a greater risk. Less faith should be placed in predictions. The first step is to recognise factual information from predictions / assumptions.

Mixing both fact and prediction taints factual information with subjectivity. For instance, Nike Inc is a world leader in sports shoes and clothing (fact). Given its market leading position, its sales should continue to grow at roughly 8% p.a as it has done for the past 5 or so years. The second part of the statement is a prediction. The amount of revenue growth it will achieve is not clear and not guaranteed. Although Nike is an innovative company that constantly reinvests in research and development, there remains a level of uncertainty that needs to be acknowledged.

The first step of sensibly predicting the future is to determine today’s value based on today’s data. Assumptions can be made but do this separately and attach a separate value for assumptions. Without distinguishing between fact and forecast, we can’t be clear on how much of our decision is grounded in fact or based on blue sky assumptions.

Start with the facts, not opinions

Any prediction of the future should first start with today’s facts. For a company, the current value can be determined with great certainty based on the facts presented in a company’s financial statements. Investigate any other hidden value the company might have. For example, does it have any subsidiaries that need to be revalued? Other assets such as land or options which aren’t regularly revalued may also be a source of hidden value. Companies may also have secured long term contracts with its customers which will have value. Today’s facts should lay the foundation for the overall analysis of a company’s future prospects. At this point, make no assumptions yet, this is the next component of the company’s value.

Nike is a powerhouse brand, its low level of debt and its continuing pipeline of patented technologies is a genuine intangible asset that is a threat to any competitor contemplating entering the sports shoes market. It also has a strong culture through the everlasting spirit instilled by founder Phil Knight via his holding company Swoosh LLC.

To value Nike, we should start by focusing on existing facts and ignore any predictions for the time being. Assuming no future increase to its 2017 reported EBIT, my estimate of value for each Nike share is USD $25-$28. This value is my estimate of what Nike is worth based on its most recently announced earnings – no blue sky assumptions at this stage.

Forecasts – the possible, plausible and probable

The difficulty with predicting the future is because history doesn’t repeat itself. But for certain companies and industries, forecasts can be relatively stable. For example, Nike competes in markets that are more mature and stable than tech companies like Amazon. The markets that Amazon competes in are new and evolving, whereas the demand for sports shoes is relatively stable – weekend warriors will continue to compete in their favourite sports.

Leading New York University finance scholar Aswath Damodaran favours the use of three categories when evaluating a forecast: possible, plausible and probable. By evaluating a forecast as either possible, plausible or probable, it becomes clearer to an investor how much reliability should be placed in any forecast.

In the case of Nike, whilst it is possible that new competitors will take market share away from Nike, I think this is not a plausible scenario over the next 10 years.

The probable outcome is that Nike will remain ahead of its competitors Adidas and Under Armour. It will remain a strong brand through its innovative founder-led spirit and its product lines will continue to expand.

I think it is probable that Nike will continue to grow revenues at an average rate of 8% p.a over the long run and continue to generate it’s very high returns on invested capital (currently around 25%-30% p.a). By separately valuing the growth component of Nike, I think that Nike is worth around USD $60 to USD $65 per share (an additional USD $40 for growth), compared to its current stock price of around USD $59.

A sensible approach to the unknown unknowns

The current value of a company (based on today’s facts) combined with the forecast (taking into account likelihood) gives us a holistic prediction of the company’s future value. This framework minimises the risk of misjudgement but it doesn’t eliminate the risk of unforeseen circumstances – the unknown unknowns.

Unknown unknowns such as wars, political crises, natural disasters may strike and disrupt the original forecasts that were made. These risks will always exist and shouldn’t prevent a sound investment from being made.

Unknown unknowns will always exist in the financial markets. Even the most sensible predictions are never guaranteed. One way to approach the unknown unknowns is to judge how likely the company is to survive any external shocks. Unknown unknowns will affect all companies, but those with low debt, strong market positioning and quality management will survive these unforeseen shocks. These are the attributes I look for to buffer against the risk of unknown unknowns.

Applying the framework

The framework for predicting the future can be thought of like a tree. The current facts form the roots and trunk, forecasts form the branches and the unknown unknowns form the leaves. Sound predictions will be grounded in a solid foundation of facts. Forecasts should be used, but only if the likelihood is high. Uncertainty will always exist but if the prediction is grounded in a solid foundation of facts, it will be clear what impact unforeseen circumstances may have on the prediction.

Be wary of placing too much reliance on predictions and promises of performance rather than proven factual results, especially in volatile environments. Sound investment decisions are rarely made purely on blue sky predictions.

In the case of Nike, my valuation is currently based on a strong foundation of facts demonstrated by its impressive track record and dominant market position. I have estimated the value of the company based on its current financial performance. This forms the basis of the valuation. An additional portion of value is attached for probable growth which is distinct to the base value. It is clear how much reliance I have placed in fact versus prediction. Whilst there are no guarantees in the financial markets, for a company like Nike, I get added comfort that it should be able to withstand any unforeseen risks due to its low level of debt, strong brand and founder-led culture.

This framework doesn’t guarantee investment returns like the sports almanac, but it does provide any investor with a way of thinking about the future in a sensible manner.

At the time of writing, Lumenary was an investor in Nike, but not any other stocks mentioned.

 

How to pick a good investment manager

“The most important quality for an investor is temperament, not intellect… You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.” – Warren Buffett


We are cognisant of the irony regarding this chosen topic. However it is a question we are asked with regularity. It is an important question for those who do not have the time to dedicate to stock market monitoring and have chosen to trust their funds with a professional manager. So we hope that in providing our view on this topic, we raise the awareness of what really matters to clients and drive improvement in the industry.

The decision of picking a good investment manager is an important one. It’s a decision that should not be based solely on fund performance. Doing so would be akin to buying a car solely based on its top speed. But what about other factors such as comfort and longevity? What about fuel efficiency? Does the car have enough space for your needs?

No doubt performance is one of the fundamental parameters to be considered, but equally important are temperamental factors of the investment manager. Just like a quality thoroughbred, a fund manager with the right temperament has staying power and longevity in the industry. You know they will be a front runner over the long haul.

Integrity

A fund manager with integrity pays the word more than just lip service. They will behave fairly and equitably for its investors. This extends to principles about the broader ethics of the companies they invest in. They will be transparent and communicate in an understandable, jargon-free style. They value the trust placed in them and uphold the highest ethical and moral standards.

This requires more due diligence than just reading offer documents. Importantly, aim to speak directly to the investment managers. Large investment managers may be harder to reach directly and their values diluted in bigger teams, but speaking directly with boutique fund managers is a good way to gauge if you feel a strong sense of trust. Look beyond the investment proposal and look for genuine signs of honesty. This trait is inherent in one’s personality. You either have it or you don’t. It’s not something you can learn or buy with money.

Curiosity

Curiosity indicates that the investment manager wants to learn more. Curious investment managers delve deeper into investment opportunities and will ask more pointed questions. Curiosity also hints at a sense of humility – a recognition that business models are constantly evolving and no investment manager knows it all.

Be mindful of those that exude unequivocal confidence in all aspects of their investing abilities. The test here is overconfidence. If the investment manager is overconfident, decision blind spots are more likely to lead to unsatisfactory investment outcomes.  As Warren Buffett says,

“In the world of investing a few people after making some money tend to imagine they are invincible and great. This is the worst thing that could happen to any investor, because it surely means that the investor will end up taking unnecessary risks and end up losing everything – arrogance, ego and overconfidence are very lethal.”

A good investment manager should be ‘appropriately confident’ – confident that their investment principles will serve them well, yet curious about ways to grow knowledge about new businesses and learn from past mistakes.

A pleasant outcome of a curious investment manager is that investors benefit from their expanding sphere of knowledge. They’re happy to share their knowledge and educate investors on what they’ve learnt.

Knowledge

The attributes above are temperamental for good reason. Investing is predominantly a behavioural art and success correlates highly with one’s ability to manage emotions. Temperamental attributes are personality based and can’t be learnt – they form the fundamental building blocks of a good investment manager.

But to win a race, every great thoroughbred relies on a great jockey. This is where financial knowledge is relevant. Every great investor draws upon a strong foundation of knowledge and sharp intellect. They should be appropriately qualified in finance, but more importantly, have an in depth understanding of how business strategy relates to financial theory. Their knowledge should be broad – seemingly unrelated industries can have huge impacts on business growth. Narrow thinkers would have failed to recognise the impact cloud computing would have on the traditional taxi industry.

An investment manager’s knowledge should shine through in their investment updates. Their commentary should be based on independent analysis.

Conviction

None of the above is useful without the final ingredient – conviction. When the research is done and the conclusion drawn, good investment managers won’t be hugging the index. They will have the conviction to trust their own knowledge and avoid over-researching. If necessary, they’re prepared to go against market consensus.

Luckily, the job of picking a good investment manager is easier than picking the winner of a horse race. It’s picking the winning horse over thousands of races, not just one race – and good horses with the right temperament and jockey will outperform over the long run.

Should investors adopt short-selling?

Short-selling is a trading strategy, not a long term investment strategy. It relies on correctly identifying both the direction of the stock price movement and then anticipating market sentiment. The “difficulty to benefit” equation is not one we view favourably

Taxes and interest are hidden costs that further erode any potential short-selling profits


Profiting from market sentiment

Since the start of this year, Harvey Norman (HVN) and Myer (MYR) have been on the receiving end of increased short-seller activity. The stock prices of both retailers have decreased significantly since the start of the year with the imminent arrival of Amazon(AMZN) to the Australian retail market.

Source: AFR

Whilst many have found success with short-selling strategies (think the film The Big Short), we are not proponents of this style of investing for three main reasons. First, short-selling relies on predicting market sentiment. Short-selling relies on being ahead of the market and selling before the rest of the market does. Unlike how it is portraying in The Big Short, this is difficult to do consistently over the long run, as every short sale relies on a buyer who believes in the opposite – that the stock will appreciate. With the high level of public information available today, we are sceptical of those pundits purporting to be able to consistently out-predict the market. It is for this reason we do not play the short-term trading game.

Second, not only is the level of difficulty high, but the rewards are capped since stock prices can never fall below zero. We prefer to target investments that produce profits in the multiples and short-selling does not allow that to occur. From our experience, good businesses return many multiples over the long run and gains are limitless.

Third, the short-selling strategy is very rarely based on objective information. For example, the impact that Amazon will have on Harvey Norman and Myer is based on modelling and assumptions made by analysts. The market cannot accurately quantify the exact impact to Harvey Norman or Myer’s profitability. And because the trade is based on subjective information, ie the imminent arrival of Amazon, this information is available to all and not highly reliable.

Hidden costs of short-selling

It is important to highlight the impact of taxes and interest cost to the short-selling strategy which erode any profits of short-selling. Trades that occur over a period of less than one year incur a higher tax rate. Moreover, short-selling typically involves paying an interest charge during the period which the position is held, which is the cost of waiting for the stock price to fall.

The “difficulty to benefit” equation

The degree of difficulty of short-selling is high for the reasons outlined above, yet the profits are capped. Combined with hidden transactions costs that erode the potential gains significantly, short-selling seems to us a counter-intuitive strategy. One that increases the level of investing difficulty but has a cap on increased profit potential.

For us, our profitability has come from taking advantage of market sentiment that has presented itself, not predicting market sentiment. As Warren Buffett aptly describes his approach judging the “difficulty to benefit” equation: “I like to go for cinches. I like to shoot fish in a barrel. But I do it after the water has run out.”

The outcome of how the recent short-selling activity plays out may well present us with interesting opportunities should the market overreact. That is when we will join the party.

Beware of the one-trick pony

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?

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

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