Foxes and hedgehogs – 1st quarter, 2012
For my first commentary as an EdgePoint portfolio manager, I’ll start by briefly introducing myself. Then, it might be insightful for you to learn what I find most attractive about working at EdgePoint. I’ve been in the investment business for over 20 years with a pretty even split between my time spent in sales, marketing and investments. I’ve always been passionate about investing. A career change in the early 2000s allowed me to evaluate what I wanted to do for the rest of my life and I decided that becoming a professional investor was the answer. When the opportunity to join EdgePoint arose, I was ecstatic to be part of a company owned by investors, for investors. I hope that I’ll be here until I’m put in a casket.
Throughout my investing history, I’ve adhered to one investment philosophy that I and the Investment team have an unfailing belief in. Evolved by Bob Krembil, this approach demands focus, discipline and, most importantly, natural curiosity – qualities that appeal immensely to me personally. My father is a retired engineering professor and through the influence of nurture it makes sense that these beliefs are a big part of my makeup! My father was also interested in philosophy, with his main influences being David Hume, Immanuel Kant and Marshall McLuhan. Needless to say, growing up there wasn’t much business talk around the dinner table. Our discussions about different ways of thinking are at the root of what led me to EdgePoint, its people and its investment approach. Fundamentally, I believe the world is filled with complexity and ambiguity. I’ve learned to be careful about the assumptions that go into decision making and to not be so dogmatic about my choices that I can’t change my mind.
While we describe our investment philosophy as deceptively simple, we understand “Everything should be made as simple as possible, but not simpler,” as Albert Einstein once said. Investing is difficult, and full of noise, emotions and unpredictable events. We do our best to make it as simple as possible, but not simpler. Here, I hope to provide some deeper insight into how we think since commentaries are often about what investors think. To do this, I’ll borrow from Isaiah Berlin who in the 1950s wrote an essay that used a metaphor to describe two main types of thinkers: foxes and hedgehogs. Berlin derived his essay from the Greek warrior poet Archilochus who wrote over 2,700 years ago that, “The fox knows many things, the hedgehog one big thing.” Berlin writes that foxes are cautious, see the world as multifaceted and don’t provide absolute, sound-bite friendly views. Rather, foxes choose to focus on a few probable outcomes or scenarios. On the other hand, hedgehogs focus on one big idea, have extremely strong convictions and an ideological leaning associated with their singular view.
When I think of how we invest, it’s clear to me that we’re much more the fox than the hedgehog. The investment world is full of hedgehogs and it’s important to distinguish between the two ways of thinking. As foxes, we create investment portfolios diversified by idea. We try to know many things as opposed to one big thing. In evaluating an investment opportunity, we look as much for what could go wrong as what could go right, analyzing multiple scenarios and investing when the most probable outcome seems extremely positive for above-average returns. Doesn’t mean we’re always right. To help ensure we’re more often right than wrong, we continuously evaluate our investment theses to stay fully aware and self-critical about our potential biases. We embrace any uncertainty by operating within a narrow emotional band. At times, this may mean standing apart from the crowd and buying or increasing a position when most investors are doing the opposite. At other times, we may conclude that the crowd is right and act accordingly.
In contrast, hedgehogs have one big idea and build an investment portfolio around it. Hedgehogs are those investors willing to convince you that you must own a certain investment. Popular hedgehog ideas right now include China, emerging markets, oil and gold. It’s because of hedgehogs (think of those on CNBC or BNN) that you may feel compelled to invest in the flavour of the month. Hedgehogs are persuasive and full of sound bites that make them media friendly, and you’re more likely to see a hedgehog than a fox on TV.
Even if you aren’t a fan of hedgehog-like thinking, you may nevertheless own a hedgehog-like investment if it resembles the S&P/TSX Composite Index. Almost half of the index (depending on how you allocate the industrial segment) is weighted in resource stocks, making it very much focused on one big idea. In owning such an investment, you’re making a hedgehog-like bet that China’s demand for resources will continue at a similar pace. Also, that resource companies won’t overinvest, leading to an oversupply of commodities and thus lower prices. If you were investing in the 1990s, this experience may sound familiar. You may have owned what you thought was a well-diversified fund only to find out in the early 2000s that it was actually very close to a pure technology fund.
In looking at the S&P/TSX, a fox might ask if it’s reasonable to expect China to continue growing its GDP at a rate greater than 9% (very uncommon for any major economy in history) and if that growth continues, whether it’s powered by infrastructure investment, the main driver for commodity demand. The fox may also ask if it’s reasonable to expect that there won’t be an overabundance of commodities given the investment in new supply over the last 10 years. A fox-like thinker will want to understand different scenarios and say there are a few probable outcomes regarding China’s demand for Canada’s commodities over the next five-to-10 years. The hedgehog who believes in China is more likely to explain in convincing fashion why continued strong demand for Canada’s commodities is probable.
Why does this discussion of foxes versus hedgehogs matter? A Stanford professor named Phil Tetlock conducted a large study of 284 experts from diverse fields that measured their forecasting abilities. He found that foxes achieve much better outcomes than hedgehogs in their decision making. Tetlock believes this is because hedgehogs tend to place far too much belief in highly improbable outcomes. When faced with conflicting evidence, they resent and resist the opportunity to change their thinking and are more willing to stay vested in it, sometimes to the breaking point. (Does this sound like the tech bubble spawned by the belief that the Internet would change everything?). Hedgehogs tend to suffer from overconfidence and confirmation bias in that they’re willing to value only information that reinforces their original thesis. Foxes, however, are more self-critical and adjust their thinking in the face of contrary evidence. They’re skeptical of grandiose schemes and even their own predictive ability. Tetlock has concluded that these qualities make foxes the better decision makers.
As investors at EdgePoint we’re generalists, meaning we know a lot of things about a lot of different businesses. Our portfolios are diversified by idea and thus we’re very fox-like. We’re experts in our investment approach, not in what the companies we own do daily. That’s not to say we don’t have a deep understanding of our holdings. Simply that none of us will ever be asked to speak at a semiconductor conference on International Rectifier’s gallium nitride technology. International Rectifier is a business we own that manufactures power semiconductors. We may believe its know-how will be a significant contributor to its future growth and seek to better understand, continually over time, how this will increase the company’s revenue and earnings. But if we see convincing evidence to the contrary, we’ll adjust our position accordingly.
We’re also aware that while we know many things about a great number of businesses, we each have what Warren Buffett refers to as a circle of competence. We understand that investing is complex, and that we all have certain strengths and weaknesses. I’m weak in understanding financial companies and because of this tend to shy away from them. Others on the team are more confident in understanding financials so if I uncover an idea in this area, I’ll bring it to them. Although we’re fox-like thinkers, we don’t necessarily all think the same way or get excited about the same investments. We’re there to bounce ideas off one another.
We try to understand our biases and point them out to each other when evaluating an investment. A great example of this that we’ve mostly overcome from our career beginnings is a bias toward low valuation. We’re sensitive to valuation but continually remind ourselves that a quality business with a high, and highly probable, growth rate and ability to reinvest its free cash flows at a high, and highly probable, return trading at a high multiple may provide greater results than a business with a low multiple and none of the aforementioned characteristics. (Sidebar: “Multiple” measures the price paid for a stock relative to the underlying business’s annual profits). We have other biases that we must recognize and overcome to be even better investors.
In creating portfolios based on knowing many things about a lot of businesses, we don’t want to end up with too many ideas. Our investment philosophy leads us to focus on a small number of investments. (Currently 34 in EdgePoint Global Portfolio, 9 of which overlap with EdgePoint Canadian Portfolio; and 35 in EdgePoint Global Growth & Income Portfolio, 13 of which overlap with EdgePoint Canadian Growth & Income Portfolio). This allows us to develop and maintain a deep understanding of those businesses. Given that our portfolio turnover should be no more than 25% over the long term, we need to find just seven or so new ideas yearly. Only what we believe are the best investment ideas make it into our portfolios. This short list of names, low portfolio turnover and deep understanding of our investments also ensures that we truly know and have context for any uncertainty surrounding them. We act rationally and unemotionally to such uncertainty. To succeed in our goal of achieving superior 10-year returns, we’re prepared both emotionally and intellectually to seize opportunities created by uncertainty. We’ll try to do so with lucid and thoughtful analysis rather than being prey to our emotions or dogmatically upholding a singular point of view.
Where has my fox-like thinking led me since joining EdgePoint on May 5, 2011? So far, ideas I’ve contributed include a pipeline company, an industrial company and a wireless technology company all from the U.S.; Atos, a France-based IT consulting and transaction processing business; a medical diagnostic company in Japan and, from Canada, a communications technology company and auto parts supplier Martinrea International Inc.
Global equity comments
The U.S.-based pipeline company is SemGroup Corp. I originally came across this business on an investment blog, which had a decent introductory write-up although I disagreed with its conclusion on value. SemGroup was an interesting investment opportunity in that the company had recently gone through bankruptcy and had no brokerage analysts covering it. This creates a bit of an information vacuum and the perfect opportunity for a fox-like investor to roll up their sleeves and do some fundamental research to develop a view on the business since no one else is providing one. I sat on the idea as we often do when something looks interesting but overvalued. The business is simple to understand and research. Some knowledge of the Federal Energy Regulatory Commission guidelines for pipelines was required as well as some basic math on increased throughput for the pipeline and its storage capacity. In addition to reading their annual and quarterly filings, and listening to conference calls, we had two telephone meetings with company management. Our investment thesis was predicated on the belief that investors weren’t recognizing the company’s growth opportunities and that these opportunities would require little capital to be realized. Also, management discussed the ability to surface value through a Master Limited Partnership conversion. Similar to a REIT or income trust, this allows all pre-tax income to be paid tax-free to investors. In October 2011, SemGroup received a $24 unsolicited bid from Plains All American Pipeline. The offer was rejected by the company as opportunistic and we agreed. We believe SemGroup’s value is considerably higher than $24, and the market appears to agree as the stock closed at $29.41 as at March 31, 2012. Our average cost is $23.57.
Canadian equity comments
Martinrea International Inc.
For the last three years there has been no shortage of hedgehogs telling us that the North American consumer is too indebted to spend money as in the past. Given the price of a new car, it surely tops the list of things a hedgehog doesn’t think consumers are able to buy. What we found, however, going back to 1980 was that per capita ownership of cars has remained amazingly stable. When you factor in population growth, the appropriate number of annual auto sales in the U.S. should be about 17 million units. In 2011, sales were running at only about 13 million units leading us to believe there was significant pent-up demand to purchase a car as consumers continued to deleverage. This wouldn't happen overnight but when you have a longterm investment horizon you can patiently wait for those extra four million automobiles to be sold. In talking to Martinrea, we also learned that the major automotive companies like GM, Ford and Nissan were consolidating the number of suppliers they dealt with. In one large platform, they were moving from say, eight suppliers to five suppliers, and wanted to deal with just those companies that were the most financially stable, companies like Martinrea. With $2.2 billion in revenue, Martinrea was already a significant supplier to these automotive companies and we felt it was a good investment idea. Our average cost per share for this company is $7.25. Today (March 31, 2012), it’s trading at $10.60 and while its share price has appreciated substantially, we’re still optimistic about Martinrea's prospects and continue to hold the investment. Being a fox-like investor is fulfilling, fun and interesting. Being part of EdgePoint makes it all the more rewarding.
All of this talk about our fox-like thinking may leave you wondering, "What about EdgePoint?” Our uncompromising belief in one investment approach and limited number of products seems more hedgehog-like, doesn’t it? It’s true that while we’re more fox-like as investors, we’re hedgehogs when it comes to the business of EdgePoint. The investment industry is expansive and offers many alternatives. We’ve chosen not to be all things to all people.
Also, we adhere to one investment approach with an unwavering commitment. This may lead to short-term business risk as there will be times when we look wrong and don’t provide superior investment results. You may then question your commitment to EdgePoint. But over the long term, our investment approach has proven successful time and again. We steadfastly believe that we provide the best way for you to achieve your financial goals. We thank you for entrusting us with your hard-earned savings and will continue to work hard to help you build your wealth over the long term.