Recent significant, unpredictable events, (Brexit, trade wars, COVID-19), should be a reminder of the value of long term investing. There is a time arbitrage to be enjoyed by investors able to look far beyond the next quarter or year. With average investment holding periods a mere matter of months, this is not the case. And we don’t expect it to change.
Large asset managers have marketing-led investment strategies. They’re trying to create an investment strategy they think will sell. That tends to lead them down a path of having niche investment universes predicated on analytical edge. See for example the use of proprietary idea generation funnels in marketing presentations, and the employment of large research teams to advertise analytical superiority. What’s the issue? There’s an asset gathering imperative in the asset management industry. This is a scalable model. It’s tempting to grow assets and rapidly increase the profitability of the business model. This imperative can become misaligned with the providers of the capital under management. If you have an investment management business owned by shareholders, there’s clearly an obligation to those owners to maximize the profitability of the investment management firm. There are ways to enrich the owners of an asset management business that are consistent with compounding LPs’ capital, and there are ways that are inconsistent. An asset gathering imperative is mostly inconsistent. Having managers with high levels of insider ownership and their own funds is consistent. Having a performance fee-led structure is consistent.
Pressure to sound smart encourages detailed, but ultimately reductive, financial forecasting. But we’re not operating in a linear system. In meteorology, if someone opens an umbrella, it doesn’t affect the accuracy of the weather forecast. Markets and economies are reflexive systems. They’re not like meteorology. If a macroeconomist advocates for raising interest rates because of his expectation that inflation will increase, to what extent is he or she incorporating the feedback loop of employees asking for higher wages in response to that expectation of high inflation? Indeed the volatility of stocks in the near term certainly makes predicting share price movements exceptionally difficult. Recent events could not provide clearer evidence of this. Macroeconomists can’t predict economies; they predicted two of the last 150 recessions. Chess, which is a reflexive game materially simpler than an economy or a financial market, has 10 to the 120th possible moves. Guessing share price movements is difficult. Stock market volatility in the near term is extremely high. It is therefore an obvious advantage to look further out. By simply lengthening one’s investment horizon, and by estimating the long-term prospects of businesses and not the short-term movements of their quoted prices, competition is lower and the prospects for a good outcome are better. We suggest that trying to understand and analyse a reflexive complex system such as the financial market is a low return on investment exercise. Intellectual effort is better directed to independent research on the fundamentals of companies. Having a large investment universe and a concentrated portfolio facilitates focus on the large gaps between price and value. With this approach, one doesn’t need to guess quarterly EPS estimates to find 10% upside.
But we don’t expect long term investing to become more competitive. Large asset managers with an entrenched LP base are not positioned to improve the quality of the LP base organically. They’re stuck with it. Asset gathering mandates have typically led to unidirectional marketing processes; that is, the manager pitches his fund to prospective allocators and current investors. That potentially leads to situations in which the investor and manager are incompatible. That can lead to sullied reputations and procyclical capital flows. Short-term capital leads to short holding periods, and again, pressure to predict share price movements. Annual incentives at large investment management firms cause fund managers to try to lock in their bonuses, to make short-term investment decisions, and to trade frequently. Having a performance fee-led structure avoids the temptation to risk substantial assets. Smaller, independent, managers have an opportunity to organically create an aligned LP base. That aligned LP base allows us to buy securities from sellers who are selling for non-fundamental reasons. That could be because they have procyclical investors, and therefore, they’re funding redemptions, or because they think the news flow will be negative over the short term. That’s due to them having eight-month holding periods.
Credit conditions of recent times have possibly allowed weak companies to thrive. This event-driven macro crisis may expose those firms who have been swimming naked. Likewise, investors, seduced by a decade of low finance costs, have geared up their investments, leaving them ill-equipped to invest countercyclically. Both dynamics may exacerbate quoted price declines. We must not be a bystander. Knowing what to do in a crisis and being able to do it are two different things. Our companies are appropriately capitalised, we do not employ leverage at the portfolio level, and our investment process, capacity constraints and working environment allow us to act decisively when the odds are overwhelmingly in our favour. We are optimists. We think that makes us sound less smart than pessimists, but we are not in the business of convincing others of our intellect. As optimists, we believe in the forward progress of humans and humanity. But we believe that volatile markets present special opportunities to make money, although it may not feel that way at the time. Decision making in periods of collapsing share prices determines long run investment success; such environments offer up choices which can materially alter the course of future investment results. In times of economic stress and market dislocation, sound judgment has the potential to be most lucrative. Stress biologically shortens one’s horizon. Myopic loss aversion increases in crises; our ability to exploit the institutional constraints of our competition matters now more than ever.
By Mark Walker, Managing Partner at Tollymore Investment Partners