What investment style will be best suited to markets where returns are limited? This month we suggest that business culture and it’s ability to strengthen intellectual resources plays just as important a role in the sustainability of a client’s risk-adjusted return.
“The strongest assumption behind the law [of active management] is that the manager will gauge the value of information accurately and build portfolios that use that information in an optimal way.”
Dr. Richard Grinold
What differentiates a value investor from a growth investor? We believe the value investor places price beyond all other factors. The difficulty with this approach is that an investment that looks cheap just gets cheaper – the well‐known value trap. A growth investor, who covets appreciation of underlying capital, can get caught by overpaying for future growth by utilizing unrealistic forecast assumptions.
As we continue our series on future investment returns, we consider the investment style that will succeed in times of rising interest rates and declining equity multiples.
Of course, in a low‐return environment the investor is challenged to take on more risk; we all understand the higher the risk, the greater reward. The biggest attraction to Las Vegas is the potential for a big payout on a small bet. Even though the odds are stacked against them, people flock to the tables in the hope of a “big win”. As we’ve written previously, Michael Mauboussin once wrote that games like roulette and the lottery are pure luck, with winnings coming simply by chance, and that even skilled players resort to a zero‐sum game.
Unlike the big bet, the rational investor should seek out good assets to invest in, those that create wealth over long periods of time. A company that is earning a high return on its capital will see its intrinsic value grow similarly regardless of how Mr. Market’s emotions are on the stock price at any given time. This type of high quality company – which is better reflected by the stability of the business and its enduring competitive advantages – would be every investor’s panacea if, in fact, they could envisage the stock price several years into the future.
In a recent paper by Gelderen and Monk, they argue “a skillful asset manager maintains and creates superior knowledge and knows how to apply that knowledge effectively.” The management of knowledge – plans expectations, and frameworks – are slowly being considered by a few within the industry. We are beginning to recognize that superior knowledge today may become obsolete over time. Again, the rational investor may recognize what worked in the past (increasing performance) may not be working now (decreasing performance). And yet the investor may be resistant to change as it moves them out of their comfort zone.
Mats Alveson’s article entitled “A Stupidity‐Based Theory of Organizations” contends that many asset management organizations refuse to use intellectual resources outside a “safe” terrain to avoid the costs associated with broader critical thinking. The investment platforms of large mutual fund investment organizations reflect this thinking – their design around mirroring passive returns is more about not losing stature than providing their clients with potential investment growth. Clearly ego outweighs knowledge in these organizations.
As we look past the present bull market trend and into benign capital market returns (see our monthly comment this past February), knowledge – or more specifically, the ability to identify, categorize, and value opportunities over a specific time horizon – will become more paramount. And investment organizations that do not adopt a system of knowledge management/enhancement to improve their intellectual resources risk providing their clients with mediocre results. Of course, emphasizing “culture, communication, and cooperation,” were identified by authors Ashby Monk and Dane Rook as being essential to future success.
An active investor can “tilt the odds” of success by buying higher quality companies which, because of their stability, provides greater confidence to forecast margins and cash flows. But refining knowledge to recognize changing future conditions will ensure a foundation for sustainable performance.
