In Are the Principles of Modern Finance Redundant?, James Anderson, who is also the co-manager of the Vanguard International Growth fund, shares with us some important academic research that gets to the crux of his investment approach. The key questions are:
- Do stocks outperform treasury bills?
- Is it ethical to teach that beta and CAPM explain something?
As a fan of Nassim Taleb, I've long held the view that CAPM and Beta are suspicious at best and dangerous at worst. The research about equity market performance is more telling though.
The abstract of the paper gives us the key takeaways:
"Four out of every seven common stocks that have appeared in the CRSP database since 1926 have lifetime buy-and-hold returns less than one-month Treasuries. When stated in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies explain the net gain for the entire U.S. stock market since 1926, as other stocks collectively matched Treasury bills. These results highlight the important role of positive skewness in the distribution of individual stock returns, attributable both to skewness in monthly returns and to the effects of compounding. The results help to explain why poorly-diversified active strategies most often underperform market averages."
So what does this mean for investors? Anderson notes:
"If returns are dependent on a very small number of exceptional stocks that compound for decades then an active fund manager surely has to concentrate on early identification of these superstar investments rather than constructing a broadly diversified portfolio at some level of volatility risk relative to an index as propounded for the last 50 years."
This explains why the Scottish Mortgage Investment Trust a) doesn't look anything like any index, which is refreshing when so many funds are closet index huggers and b) has outperformed broad market indexes massively because Anderson and his team have basically been following this strategy for a long time.
This gets to something I feel strongly about. In my many years in the investment industry I have seen so many funds charging high fees that just look their benchmarks. You are paying for alpha but you are getting beta. These closet index huggers don't have a sustainable business, because you can get on average better performance by investing in index trackers and at a much cheaper cost. You can also get alpha relatively cheaply by investing in managers such as Anderson who don't care for benchmarks and "active share" or "tracking error" risk metrics and just seek the highest returns possible with an unrestricted mandate.
So, what are the critical characteristics that Anderson looks for in investments? They are high, and initially underestimated growth, competitive moats and longevity.
Luckily, the readers of GuruFocus already know that diversification produces average returns. Anderson takes it a step further and teaches us that in a sense, less is more because the focused search for massive asymmetric upside should be our main investing preoccupation.
As a fan of Nassim Taleb, I've long held the view that CAPM and Beta are suspicious at best and dangerous at worst. The research about equity market performance is more telling though. The abstract of the paper gives us the key takeaways:
"Four out of every seven common stocks that have appeared in the CRSP database since 1926 have lifetime buy-and-hold returns less than one-month Treasuries. When stated in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies explain the net gain for the entire U.S. stock market since 1926, as other stocks collectively matched Treasury bills. These results highlight the important role of positive skewness in the distribution of individual stock returns, attributable both to skewness in monthly returns and to the effects of compounding. The results help to explain why poorly-diversified active strategies most often underperform market averages."
So what does this mean for investors? Anderson notes:
"If returns are dependent on a very small number of exceptional stocks that compound for decades then an active fund manager surely has to concentrate on early identification of these superstar investments rather than constructing a broadly diversified portfolio at some level of volatility risk relative to an index as propounded for the last 50 years."
This explains why the Scottish Mortgage Investment Trust a) doesn't look anything like any index, which is refreshing when so many funds are closet index huggers, and b) has outperformed broad market indexes massively because Anderson and his team have basically been following this strategy for a long time.
This gets to something I feel strongly about. In my many years in the investment industry I have seen so many funds charging high fees that just look their benchmarks. You are paying for alpha but you are getting beta. These closet index huggers don't have a sustainable business, because you can get on average better performance by investing in index trackers and at a much cheaper cost. You can also get alpha relatively cheaply by investing in managers such as Anderson who don't care for benchmarks and "active share" or "tracking error" risk metrics and just seek the highest returns possible with an unrestricted mandate.
So, what are the critical characteristics that Anderson looks for in investments? They are high, and initially underestimated growth, competitive moats and longevity.
Luckily, the readers of GuruFocus already know that diversification produces average returns. Anderson takes it a step further and teaches us that in a sense, less is more because the focused search for massive asymmetric upside should be our main investing preoccupation.
Tesla
A good example of this asymmetric investing has been Tesla (TSLA, Financial). For a long time and at the time of writing in November 2017, Baillie Gifford (Trades, Portfolio) was the largest external owner of Tesla. The asset manager first invested in Tesla in 2012 when the stock was around $30. In Tesla and the Problems of Finance Capital, the firm makes a valid point that negative and sensationalist headlines about Tesla are good for ratings at news organisations. Negative news stories and self-promoting short-sellers all claim they know "the truth" about Tesla. Anderson makes a very rational point about "the truth:"
"This seems to us to be a dangerous, damaging and arrogant mentality. Whether it be about Tesla or any other stock – let alone about market predictions – the uncertainty, complexity and mass of ingredients that makes up messy reality, simply aren't usefully handled by this type of dogmatism. Whether it be spot forecasts, detailed spreadsheets or price targets, the illusion of certainty is the enemy of thoughtful investment."
More interestingly, Anderson describes his Tesla investment in terms of the risk-reward balance, which sounds more like a call option. His firm's investment in Tesla was because of their opinion of a very favourable, probability adjusted, potential pay-off in consistently backing the company and its management. The asymmetry in the investment appears to be very attractive because the potential returns, and the upside potential, if Tesla were to succeed would be much larger than the size of the investment. So the point is, any single good investment isn't because your forecasts or opinion of value will be right, it's because you view the risk reward to be in your favour.
Equity markets after all are or should be about risk capital backing projects to achieve economic and social objectives. Anderson clearly admires Musk but admits he isn't perfect and that he doesn't always agree with Tesla's corporate policies. Then again, Thomas Edison and Henry Ford were not perfect either. It must be then that there is no such thing as a perfect investment but strategic visionaries like Musk are worth paying attention to.
Ultimately, if we can't make definitive projections and predictions about the future, i.e. we can't possibly know "the truth," then what we need to do is think in terms of the possibilities, likelihoods, pay-offs and track these over time. As the saying goes, "Haters gonna hate" but this isn't important in the grand scheme of things and the more we can put our own egos to one side, the better off we'll be as investors.
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