Conformity can be harmful to your wealth – 1st quarter, 2016
"Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”i ―John Maynard Keynes
I recently watched a documentary on the life of E.O. Wilson, titled Of Ants and Men.ii If you’re interested in either the natural world or human nature I highly recommend it. Wilson is an entomologist and biologist and the father of two significant scientific concepts, sociobiology and biodiversity. In the documentary, Wilson comes across as positive, engaging, curious and very much a gentleman. He seems like a good role model for growing old so I wanted to find out more about him.
I learned that Wilson was a polarizing figure accused of racism, misogyny and eugenics. Without going into too much detail, the controversy stemmed from his hypothesis that human behaviour is shaped by evolutionary forces, a combination of nature and nurture, rather than solely nurture or environmental factors. This hypothesis flew in the face of conventional thinking that we’re ostensibly born with a blank slate or tabula rasa and that our behaviour is shaped by experiences. For these views he was attacked both physically and mentally by his peers at Harvard, where he was a professor, along with both atheists and religious groups. Wilson was pretty good at upsetting everyone but he stood by his beliefs, which were based on his scientific observation of the natural world.
While Wilson had no political agenda, he argued that as scientists he and his peers had a duty to uncover the truth regardless of political correctness. I think it’s fair to say that Wilson must have felt very alone in his beliefs and I can imagine it would have been cold comfort that he found himself on a long list of great scientists who’d been attacked and persecuted for their beliefs, like Galileo Galilei. While it took time for the air to clear, Wilson’s theories ultimately led to him being honoured with scientific prizes, including the National Medal of Science in the U.S. and the prestigious Crafoord Prize from the Royal Swedish Academy of Sciences, as well as two Pulitzers. Everything I read about him confirmed that he’s the man I saw in the movie: kind, decent, thoughtful and a true gentleman.
By now, I’m sure some of you are asking what the heck does this have to do with investing? The answer is, a lot. The stock market is the product of thousands of people making independent decisions every day. These decisions are based on their beliefs, in this case on the value of a business. There’s incentive for being right and punishment for being wrong. On any given day as an investor, it can feel like you can do no wrong while at other times it feels like you can do no right.
In the short term, the market can be an exceptionally hostile place and it requires courage in your convictions to achieve success. While the circumstances and beliefs around investing are completely different from Wilson’s, the outcomes are similar.
Market circumstances are often driven by short-term reactions to economic or business activity, while disputes over beliefs are always about the true value of a business based on those circumstances. This drives stocks up or down short term. Ben Graham, the father of security analysis, said it best: “In the short run, the stock market is a voting machine but in the long run it is a weighing machine.”iii What he meant was in the short term stock prices can diverge from their true value as businesses but over the long term price and value tend to meet. This short-term disconnect between price and value is often caused by one of the most powerful forces in human nature, the urge to conform, and it’s ever-present in the market. Sometimes this herding behaviour is manic, leading to high prices like during the tech bubble of the late 1990s, while other times the herd is extremely depressed leading to market crashes like in 1987. To truly achieve success as an investor you must be able to recognize manic periods as an opportunity to sell and depressed periods as an opportunity to buy.
At EdgePoint, a central tenet of our investment philosophy is our willingness to stand apart from the crowd. This doesn’t mean we try to be different for the sake of it. It means that we’ll avoid conforming with the popular view of the value of a business if we believe it’s wrong. While we haven’t been physically attacked for our beliefs (we believe our investors haven’t had a reason to do so), frequently we’re called out to defend the idea behind one of our investments. More importantly, our psyches can be attacked day-to-day by price changes in businesses we invest in. To believe that it’s easy to feel good when the companies you invest in are down 10%, 20%, 40% or more, is to lack basic understanding of human nature. It’s mentally demanding, but only in the short term.
Gregory Berns, a professor of neuroscience at Emory University, more recently conducted an experiment that confirmed earlier findings by social psychologist Solomon Asch that only about 25% of humans have the ability to stand apart from the crowd.iv He did this by showing participants a wrong answer to a question at the same time they were trying to answer that question. More than 40% of the time participants would defer to the answer provided to them. On the other hand, only 14% answered the question wrong when no wrong answer was first introduced to them. Human beings are very willing to conform to the thinking of others even when they believe they may be wrong in doing so.
In a recent article called Animating Mr. Market: Adopting a Proper Psychological Attitude, financial strategist Michael Mauboussin quotes Berns:
“ 'We like to think that seeing is believing,' but, Berns said, the study’s findings show that seeing is believing what the group tells you to believe."v
Another element of the experiment worth mentioning is what happened in the brain of those who remained independent (25% of participants). They experienced increased activity in the amygdala, the part of the brain that calls for immediate action.
Fear is a powerful trigger for the amygdala, and it’s behind the fight-or-flight response, a psychological reaction prompting us to fight or flee a perceived attack or threat to survival. Those who stayed independent clearly have a very different way of managing the fear response than the majority of the population and they deserve admiration because of their ability to overcome such an inherent part of human nature.
Interestingly, when you look at the world of professional investment management you find the same tendency for conformity. As we see in the following chart, 50% of all managed money does nothing more than try to achieve the same results as an index like the S&P 500. While half of managed money is considered “active” note that only a little more than 20% is considered “highly active.” This is the group that we fall into and the group willing to manage investment portfolios that look different from the index. The percentage of investment managers in this category fits well with the results of the previously mentioned behavioural experiments in that only about 25% are non-conformists.
Source: A. Petajisto, “Active Share and Mutual Fund Performance”, Financial Analysts Journal v. 60, no. 4 (July/August 2013): 79-93.
Why does this matter to you as our investor? It’s important because it has been proven that truly active management as defined by two specific criteria can add value. Those two criteria are active share and tracking error.
Active share simply means the percentage of a portfolio that looks different from the benchmark index. Funds with a 60% to 90% active share have been shown to outperform by 1.6% over the long term while funds with at least a 90% active share have outperformed by 3.6% annually.vi EdgePoint Global Portfolio has an active share of 97% and EdgePoint Canadian Portfolio, an active share of 85% as at December 31, 2015.
Source: M. Cremers & A. Petajisto, “How Active is Your Fund Manager?” Yale School of Management, 2006.
Source: M. Cremers et al., “The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance,” Social Research Network, 2013.
The other important factor that isn’t talked about nearly as much as active share is tracking error. Tracking error measures the amount by which a fund deviates from the performance of its index. High tracking error will often appear when a fund is overweighted or has made a factor bet in a certain market sector like technology or healthcare. As the following chart shows, factor bets have been shown to contribute most to underperformance over time. As with so much in life, having too much of something is rarely a good thing.
U.S. all-equity mutual funds 1990-2009
Reflects annualized equal-weighted performance of U.S. all-equity mutual funds for four types of active management. Returns net of fees and transaction costs. Excludes index funds, sector funds and funds with less than $10 million in assets. Four-factor alpha as calculated by Carhart's four-factor alpha model (1997). Source: A. Petajisto, “Active Share and Mutual Fund Performance”, Working Paper, December 15, 2010.
We like to say our portfolios are diversified by business idea and we try not to have much, or any, overlap in these ideas. With no factor bets, we believe this helps create the circumstances for an appropriate tracking error and hope our approach will lead to superior long-term performance.
If the recent bout of downward market volatility has left you scared and running for the exits, you have lots of company. When stock prices are falling and investors are fleeing the market, the Asch and Burns studies would suggest about 75% of investors' peers will want to join them. Yet while the experience isn’t pleasant psychologically, it’s at this time, when the market is a voting machine that we at EdgePoint will invest more in the businesses we believe have the greatest chance of achieving above-average market returns long term. That’s because we believe that over time, the market is a weighing machine and that a business’s value and its stock price will converge. We also believe that our ability to think independently is one of our key competitive advantages.
Our approach at work
Since the end of 2011, Alere Inc. has been one of the largest equity weights in our Global Portfolio, a significant position in the foreign content of our Canadian Portfolio and a substantial fixed-income position in our Growth & Income Portfolios. Alere recently received a takeover offer from Abbott Laboratories supporting our long-term investment thesis in the company.
Alere is the global leader in point-of-care diagnostics. If your doctor has given you a strep test and got the results in 15 minutes, there’s a good chance it was an Alere test. It’s a very stable business so you wouldn’t think it would have a volatile stock price but it does.
As an investment, Alere is a great example of how we don’t follow the herd. Many times over the years of our ownership uncertainty about Alere’s short-term performance caused downward volatility in its share price. There were two FDA product recalls, several missed quarterly earnings estimates, a 50% share price drop, many daily 10% declines, an activist investor that accused the board of ignoring its fiduciary duty by not making shareholders aware of a bid for the company, and the resignation of the founder and CEO as well as most of his team. In quite a few cases the stock sold off due to these issues and we often not only purchased stock but also increased Alere’s weight in the Portfolios as you can see in the following chart.
Source: Bloomberg LP. January 5, 2009 to February 2, 2016. In US$. Weights in Cymbria as at: (1) 16-09-09, (2) 30-09-11, (3) 31-12-12, (4) 10-06-13, (5) 01-07-14, (6) 09-01-15, (7) 15-10-2015, (8) 28-01-2016, (9) 01-02-2016.
50% price decrease: September 2, 2009 to October 3, 2011. Since the takeover, as Cymbria has sold down its position, the stock price has fluctuated.
Because of our long-term belief in Alere, uncertainty and downward volatility allowed us to substantially increase our stake in the company which ultimately increased the payoff to our investors. Believe it or not, we were buying Alere at less than $36 on January 28, 2016, when it was down as much as 8.7% from the previous day’s close due to volatility in the healthcare sector. This was a mere two trading days before Abbott’s $56 takeover offer.
Alere is a perfect example of the market being a short-term voting machine and a long-term weighing machine. Stock price and business value can diverge over shorter timeframes but long term the two tend to come together. Some three years ago you could have bought Alere for $18 per share; today a competitor thought it was worth $56 per share. I don’t know if being non-conformist is the product of nature or nurture but in the case of Alere, the result has been very positive for us and our investors.
Looks can be deceiving
By Frank Mullen, portfolio manager
2016 began with headlines about the selloff in high-yield bonds and the Credit Suisse High Yield Index’s yield–to-maturity rose from a low of 6.3% in 2015 to over 9% at the beginning of the year.vii We like to capitalize on volatility as much as possible because it creates an environment that provides us with opportunities and we started to place more emphasis on finding attractive high-yield investments.
We’ve found select opportunities as a result of the volatility but as with many things in financial markets, the current environment for high-yield bonds is far more nuanced than simply saying the market is attractive and yielding over 9%. This is important for all fixed-income investors to understand, but should be of special interest to those who believe in investing in high-yield investments through passive vehicles like ETFs. U.S. high-yield ETFs have become increasingly popular over the past several years but I think investors should pay special attention to what makes up these investments. ETFs may provide an easy way to allocate capital to an asset class but investors need to ask themselves if they truly understand the exposure they have through these investment vehicles. Index investors have to realize there is no credit analysis done on the businesses that make up the index and have to be comfortable simply buying the market and not asking if borrowers have any ability to actually pay them back.
Most investors think that investing in the index provides them with a diversified basket of bonds. While there are many issuers in an index, this doesn’t necessarily mean it’s diversified. For example, if a large portion of the index is being viewed by investors in the same way and priced using similar assumptions, the index is not truly diversified since many of the underlying bonds are exposed to the same risks. I believe this is the case with many bonds in the index today which leads me to conclude that the diversification is questionable at best.
Consider the following facts:
2/3 of the underlying bonds are yielding less than the index
1/4 of the underlying bonds are trading at yields below the all-time index low of 4.89%viii
The current market can largely be broken into two buckets, bonds that are loved vs. bonds that are hated. They’re distinguished by the yields that they’re trading at. Investors love, and want to own, the two-thirds of the market that’s yielding less than the overall index. The demand for these bonds is driving prices up and their respective yields lower. The remaining third of the market is trading at much higher yields, which generally implies a high probability of default. No one wants to own these bonds so their prices have fallen to levels that result in them yielding materially more than the index. Many of them are issued by commodity-based companies that will struggle if commodity prices don’t recover in a reasonable amount of time.
Would ETF investors be comfortable investing two-thirds of their money in lower-yielding bonds with the hope of generating additional yield by taking a significant bet on commodity prices? There’s nothing inherently wrong with this strategy but investors need to understand that this is how they’re allocating capital when investing in the index today.
Index investors must also ask themselves if they’re comfortable allocating a quarter of their capital to bonds that look expensive relative to history. This wouldn’t be an issue if the fundamentals of the average borrower were significantly better than in the past but that’s not the case today. Leverage in the high-yield sector continues to rise as debt grows while revenue and cash flow have declined.ix Liquidity for the average issuer has also declined as cash balances relative to debt have fallen to a level well below the long-term average.x
To me, the obvious risk in the current environment relates to the group of bonds trading at very high yields. If their business fundamentals don’t rebound and they default, investors may not get the recovery value they are hoping for. This would surely be a risk with any bond yielding over 15%, as many oil and gas producers currently are. Don’t get me wrong, there could be great companies in this segment of the market where pessimism has impacted the price but thorough credit analysis is required to separate the diamonds from the rough.
A less obvious but perhaps larger risk comes from the majority of the index that everyone wants to own, driving their prices high and respective yields low. These are companies that the market has deemed safe largely because they aren’t exposed to commodities. But these “safe” businesses could also be trading at prices that are too high. The majority of these companies still have significant amounts of debt and on average their business fundamentals are getting weaker.xi Paying historically high prices for highly levered companies with declining sales and increasing levels of debt may not be the smartest decision. The price you pay for an investment dictates your potential return and risk. If you overpay for a business that the market thinks is safe, you better hope that the business doesn’t weaken, as price declines can be dramatic when a bond falls from the “safe” to “risky” category in the eyes of the market.
By investing in the index today you're exposed to these two groups of bonds. This isn’t diversification as each of these groups has a high exposure to the above-mentioned risks.
At EdgePoint, we believe that credit analysis is key to outperforming the market and strive to identify borrowers that are paying attractive yields compared to the underlying fundamentals of the business. We only allocate capital when we’re comfortable with the cash flow and asset base of a particular issue and prefer a concentrated portfolio of well-researched ideas over a basket containing hundreds of bonds.
Volatile periods, like the beginning of 2016, typically provide us with attractive investment opportunities. To date we’ve found several new investment ideas that the market views as risky, but after careful credit and business analysis we disagree. While we’ve largely found these ideas in the higher yielding areas of the market, each bond has its own independent investment thesis. We’re focusing on bonds we believe have strong fundamentals despite the fact that they may be in a weak market segment. We hope these are the proverbial babies being thrown out with the bath water.
Unfortunately the volatility we experienced at the beginning of this year didn’t last. We prefer to wait for opportunities to present themselves in the high-yield market than invest in bonds that are trading at prices we don’t find attractive. We’re happy to be patient and stand ready to act when opportunities arise again.
iiE.O. Wilson – Of Ants and Me. Directed by Shelley Schulze. Washington.: Shining Red Productions, Inc. for PBS, 2015.
iiiGraham, Benjamin and David L. Dodd, Security Analysis: Principles and Technique (McGraw-Hill Companies, 1962).
ivSolomon E. Asch, Studies of independence and conformity: A minority of one against a unanimous majority, Psychological Monographs: General and Applied, Col. 70(9), 1956, p. 1-70.
vMichael Mauboussin and Dan Callahan, Animating Mr. Market: Adopting a Proper Psychological Attitude, Credit Suisse, February 10, 2015.
viCremers, M. and A. Petajisto, “How Active Is Your Fund Manager?” Yale School of Management, 2006.
viiiCiti Research, US Credit Weekly, “Not your average bond”, March 18, 2016.
ixMorgan Stanley Research, Bloomberg LP, Capital IQ.