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.

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.