Techniques to limit things going wrong

CIO Insights 4Q2013

In equity portfolio management, we believe it is imperative to prevent “own errors”. As is the case in technical sports such as baseball, tennis or snooker, one needs to be concerned first about not committing glaring mistakes and only then trying to hit the winners. In a day and age when opinion leaders are preoccupied with identifying brilliance rather than restraint, this may sound unspectacular or even dull. However, in our line or work it is a judicious course of action to follow and we mainly employ four methods to implement it.

First, we do not want to fall prey to the money flow/liquidity trap. For example, widely applied approaches such as index-driven, momentum or chart-technical investing do not primarily attempt to distinguish between price and value. Rather they tend to allocate money to those stocks that are big enough to be readily traded in large quantities and to those that have been going up recently without considering what they are fundamentally worth. We are convinced that trying to establish a “margin of safety” (i.e., the difference between what we pay and what we get) is a decisive factor why classic value investing has been shown to yield superior results over time.

Second, we tend to avoid business propositions in emerging growth (young, unproven), high-tech (vastly dynamic), fads & fashions (at the mercy of consumer tastes) and other exciting areas. A few companies with such attributes obviously can deliver what they promise and sometimes much more. The problem in our view is that their prices are usually too rich in risk-adjusted terms because everybody keeps looking for them. In other words, we suspect that financial markets tend to be too efficient in order to be able to systematically buy high-expectation stocks at prices attractive enough to offer a satisfactory portfolio return over time.

Third, we esteem independent decision-making as a rare and precious asset. An often-heard adage in investing is that “the markets are always right.” We believe this statement to be highly dangerous. On the one hand we would certainly agree that free markets provide us with an excellent price finding mechanism. On the other hand, it is equally obvious to us that they are heavily and regularly impacted by myths, noise, behavioral biases and other irrational factors. The best way to deal with these countervailing forces is to think things through as autonomously as possible, to strictly follow one’s own discipline and to “use” the markets only if and when a transaction can be executed under clearly advantageous conditions. Somewhat paradoxically then, refraining from following common conventions is a crucial way of preventing own errors – after all, in the end if we make a wrong decision, we never ought to blame the markets or the companies we invest in, only ourselves.

Last but not least, we prefer statistics over bets. That is, the Fund’s returns should be driven by the mechanics of its investment process that is stringently adhered to over time, rather than by outsized returns generated periodically (be they positive or negative) in individual stocks. Our purely valuation-driven and unemotional investment process depends on what we call (1) replicability/breadth, i.e. being able, at any given moment, to apply it to unique investment situations across varied regions, countries, industries, company sizes, competitive dynamics, customer groups and other features; and (2) repeatability/depth, i.e. being able, over time, to draw on an ample supply of new opportunities upon the sale of an existing portfolio position, the reinvestment of dividend income or the deployment of money inflow.

Sincerely,