“[Benjamin Graham’s] … vantage point was from the perspective of eternity and calamity – timelessness and a worst-case scenario to arrive at a margin of safety.” Christopher M. Begg, Founder and CIO of East Coast Asset Management
Many approaches to equity investing either overlap or disjoin according to underlying principles, be they quality, value, growth, capital cycle, thematic, behavioural, or some combination. A multidisciplinary perspective enables a broad scrutiny of investment decisions and also serves as a wellspring for inspiration and creativity, akin to Charlie Munger’s ‘latticework of mental models’. Otherwise, the daily pursuit of shareholder value is littered with distraction, vignette, portfolio construction gimmicks, and models that stand for nothing.
Like many others, we seek insight through equity factor construction and statistical analyses, primarily as it pertains to risk control. We don’t, however, seek the ‘investment truth’ in these things. It’s vital to discern causality from coincidence and narration from science, particularly when a story coalesces around hard-looking numbers. Historical back testing and even great live track records are dangerous primarily when a mistaken belief of completeness or inevitability is attached to them. While a good econometrician will always relish new and interesting data points to improve a model, it is small consolation to investors who may have inadvertently signed up to a ‘crash-and-burn’ teachable moment.
Bad returns at bad times are just bad for investors
More return with less risk is the best achievable outcome for investors, and those who forfeit that objective should feel a twinge of guilt. Beside the false inevitability of joining more risk with more return, from a total portfolio perspective, riding junky, leveraged, cheap ‘value’ companies on the way down is its own kind of punishment, not compensated by any commensurate rise on the way back up. Bad returns at bad times are just bad for investors.
Begg’s invocation of eternity and calamity is close to our abstract views on quality and value.
“Intelligent people make decisions based on opportunity costs.” Charlie Munger
Risk and time are the price of admission
Successful equity investing usually requires investors to forego their capital for an extended period of time. The question is: how do investors trade this opportunity cost most wisely? As risk and time are the price of admission, what are the appropriate rewards to seek for bearing these costs, or else avoiding them altogether?
The relevant risks are two-fold: instability/volatility and the potential for the permanent loss of capital. While equity investors can afford a certain amount of return volatility, they can’t afford the permanent loss of their capital. We therefore orient our process to rest on sure fundamental footings. The exit strategy from investments is the cash flows generated by the businesses, not the hope or expectation that the market will bail us out in one form or another.
The concept of time is more nuanced and encompassing, more given to abstraction and imagination. While we experience time sequentially, we routinely abstract from it to consider events that are distinct to the current set. This is a very useful thing to do, not least because it helps guard against real dangers that have no immediate precursor.
“All a musician can do is to get closer to the sources of nature, and so feel that he is in communion with the natural laws.” John Coltrane, legendary saxophonist and composer
Eternity and calamity
Calamity, while usually absent, is the event that needs be accounted for in the fullness of time, to avoid courting disaster. ‘Quality’ should be the invariance of a profitable business franchise, unconditional on any particular events occurring or not occurring. But don’t conflate quality with growth as some do. Unprofitable growth is the definition of value destruction, while a profitable but static or even shrinking business only requires non-reinvestment to achieve nearly perfect investment results, potentially more reliably. And don’t conflate quality with capital cycles, as there’s no such thing as conditional quality. The steady characteristic of quality is paradoxically only visible through time, and so one point in time tells us nothing very meaningful about quality.
What we commonly refer to as value is the recognition that a business may be trading close to its worst-case scenario. It may be experiencing its own version of calamity in its fundamental performance, market perception, capital cycle, or some combination. Collapsing the dimension of time enables us to reconcile our investments against the certainty of eventual calamity and to act upon it when it does occur, enhancing the prospect of improving conditions having representation in our portfolio.
The relationship between quality and value is only that they should be mutually consistent, and the timeless perspective helps make that more clear. One company’s version of calamity may look very different to another’s. In fact, its calamity may look nearly the same as its own best-case scenario, if it has an inherent robustness to varying conditions. Consider the industries of beer, chewing gum, or canned soup, and all the possible future events that will not materially impact their fundamental demand-side outlook. Given that’s the case, it’s no surprise that some companies look cheap or expensive based on current superficial considerations, only to switch places upon a fuller examination of what may happen.
Viewing quality as a ‘flavour-of-the-month’
Some market observers like to point out that quality, when viewed as a factor, is like all other factors in that it can become the flavour-of-the-month, overvalued, and potentially painful to investors when inflated valuations subside. We agree with this basic observation but feel it overlooks an important point.
While all segments of the market can experience over-valuation, high quality companies should not experience the same severity in the reduction of their underlying cash flows when adversity eventually does arrive. Recall that large portions of the market or economy may essentially disappear under relatively modest macro-economic pressure, following any number of plausible events. Or they may be particularly prone to capital over-investment relative to the (un)steadiness of future demand, severely impacting their profitability. Our view of quality focusses on the eventual delivery of reliable cash flows. The multi-decade recovery of the Nifty Fifty (1960’s and 1970’s ‘must own’ businesses that investors were told they could buy and hold forever) offers a kind of testament to that fact.
This consideration has bearing on the appropriateness of core equity portfolios that occupy a steady-state allocation within diversified portfolios. While value-oriented or opportunistic strategies may have their place, the deliberate move from cash into riskier assets should include a proper inventory of both the trade-offs and opportunities available along the way. We see quality as the first logical stop for consideration, especially where it is positioned to deliver relatively low risk and a strong risk/return trade-off.
Investors should not be lulled into a false sense of comfortable helplessness
Adhering to a few time-tested investing precepts turns the advantage away from the market and back to the investor, without the disconnected portfolio construction gimmicks that have more recently caught favour. We do not believe that investors should be lulled into a false sense of comfortable helplessness, placing their fortunes on overly passive or formulaic solutions that have only a tenuous connection to the discipline of investing.
Adapted for Cuffelinks from ‘Ibbotson Insight Letter’ of January 2016.
Peter Bull and Nimalan Govender are Portfolio Managers in Sydney with Ibbotson Associates, a Morningstar company with more than $180 billion under management globally. This material has been prepared for educational purposes only, without reference to your objectives, financial situation or needs. You should seek your own advice and consider whether the advice is appropriate in light or your objectives, financial situation and needs.