Behaviour As An Edge

“What’s not going to change in next 10 years?”

-Jeff Bezos

Internet, securities regulations and entry of talented individuals have blunted the erstwhile investment edge offered by better information and better analyses. Rational behaviour – buying below intrinsic value and selling above it irrespective of short term noise – still remains a sustainable source of investment edge. That’s because institutional compulsions and human emotions & biases force participants to eschew this rationality and create mispricing. These two factors will not materially change in next 10 years.

Institutional Compulsion: Investment behaviour of fund managers at investment institutions is driven by minimising career risk. Their jobs, promotions and bonuses depend on increasing the assets under management (AUM) which in turn depends on matching or beating their benchmarks net of fees on quarterly basis. Often unconventional and/ or concentrated stock picks cannot offer this guarantee. Therefore most of them construct ‘index aware’ portfolios – euphemism for mimicking benchmark indices. Many companies that are out of index donot find buyers and remain mispriced. Rising interest in Index Funds/ETFs (passive funds that mimic benchmarks fully without any human discretion) will further aggravate this anomaly. Further, redemptions or regulations force fund managers to sell stocks irrespective of value. Recent SEBI reclassification drove lot of money out of mid and small caps to large caps irrespective of fundamental merit.

Human emotions & biases: While good for hunting, gathering and surviving, evolution has ill prepared us to do well in investing. Fear and greed were mental shortcuts that helped our hunter forefathers survive. They ran when there were rustlings in the bushes (fear). And, they overate/ stored whenever food was in excess (greed). These genes are passed on to us as their legacy. Price fall triggers the same fear. Risk aversion rises and future projections get grim. No price is too low. Conversely price rise engenders same greed. Risk taking rises and future projections get rosy. No price is too high. Behavioural Finance has demonstrated that we are not perfectly rational. We are susceptible to heuristics and cognitive biases.

Behaviour Edge: Knowing above, following offers a sustainable investment edge:

  1. Operating only in businesses that one honestly understands and having a sense of their intrinsic values.
  2. Remaining humbly aware of multiple possibilities including our own folly and therefore buying with a margin of safety.
  3. Understanding that (a) intrinsic values are less volatile than price, and (b) emotions revert to mean.
  4. Raising money and/ or investing only when prices make sense (is harder than seems) and willingness to hold cash when opportunities are thin. Our ‘zero fee and profit share only’ structure supports this behaviour.
  5. Looking for opportunities in spaces where price discovery is still inefficient.

Rational Money: A fund’s behaviour is derived from its investors’ behaviour. We may, thanks to above reasons, find bargain securities and buy. Prices however may continue to fall even after that despite fundamentals remaining intact. Interim NAV performance may look poor. If investors panic and withdraw on those times, the paper loss will be converted to actual loss and all our behavioural astuteness (1-5 above) will amount to nothing. A fund manager can be only as rational as the money she manages.

Note: This piece was part of one of our half yearly letters sent to our investors.

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Human Diffuculties in Value Investing

Charlie Munger, the partner of Warren Buffet and Vice Chairman of Berkshire Hathaway, noted “all sensible investing is value investing”. There are volumes of research on the fact that despite richest investors like Buffett and Munger attributing their success and riches to value investing, majority donot follow value philosophy.

Theoretically, value investing involves buying below and selling above intrinsic value. This sounds simple and sensible. However as Yogi Berra quipped “In theory there is no difference between theory and practice, in practice there is”. Value investing, like many disciplines, is easy in theory but difficult in practice.

It is difficult in practice because it is contrary to normal human nature and accepted social norms at each of its four broad steps:

  1. Assessing Intrinsic Value : Assessment of intrinsic value involves future. The uncertain terrain of future needs large doses of skepticism, objectivity and humility over optimism, group-think and overconfidence.
  2. Buying below intrinsic value: Bargains are found amidst fear and disinterest. Owing to biological adaptation over ages, brain is conditioned to prefer flight over rational thought when induced to fright. Similarly homo sapiens have preferred staying in the comfort of popularity over the risky pursuit of contrary solitude.
  3. Waiting: Most money in investing is made by waiting, not frequent trading. In a world where activity is looked as synonymous to progress, the notion of buying and doing nothing for days stimulates guilt glands and consequently needless actions.
  4. Selling above intrinsic value: Price rise intoxicates human mind. It forces it to keep on dancing long after the music has stopped. Greed, hubris and envy are all at play here. It requires an objective, non-greedy mind to stop dancing before the music is going to stop.

Overconfidence, fear, safety in crowd, needless activity, greed and envy are powerful tendencies that have served some utility in human evolution since hunter gatherer days. They are hard to resist and they operate automatically.

Value Investing calls for curbing these tendencies. This is hard to do. This makes value investing anathema to us homo sapiens. Fortunately, being aware and alert to the nature, cause and stimulant of these tendencies has proved to be a working antidote for successful value investors including Charlie Munger.

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