“Let others believe markets can never be beat. Abstention on the part of those who won’t venture in creates opportunities for those who will.”
Howard Marks from The Most Important Thing
Snakes and Ladders is a classic children’s game, played between two or more players on a gameboard having numbered, gridded squares. A number of “ladders” and “snakes” are pictured on the board, each connecting two specific board squares. The object of the game is to navigate one’s game piece, according to die rolls, from the start (bottom square) to the finish (top square), helped or hindered by ladders and snakes respectively.
In a recent conversation, a good friend described the investment business as a game of snakes and ladders, with the current turmoil one of the obvious long‐tail snakes on the board. It’s a reasonable analogy – but have you ever looked closely at the board? As the player gets closer to the game’s end, there are many more “snakes” to test you and fewer “ladders” to provide the wanted boost.
Simplistic, but a metaphor for the challenges faced by active portfolio managers. But if we turn the idea on its head for a moment, the snake also presents an opportunity for the active manager to catch the next ladder to end up further ahead than when you started. To understand this, one must understand the nature of active versus passive management.
In its very simplest form, investing can be described as the allocation of capital to either entrepreneurs or company management requiring funds to seed an opportunity to generate profits. By that description, it is the active manager’s responsibility to evaluate each of those opportunities – its potential along with its corresponding risks – against the price paid to participate in the opportunity. The difference between good and bad active management is simply the capability and depth of the research in evaluating the opportunity set.
Passive investing on the other hand, is simply the process of allocating capital across all opportunities available without any reference to the corresponding risks and potential rewards of each prospective opportunity. It certainly fulfills a purpose – after all, cheap market access provides better value than poor active management.
Of course, given the drive to prove investment prowess through increased complexity, our industry has further confused investors by communicating strategy in terms of industry and country allocations, factor tilts, investment “styles”, momentum algorithms, mean reversions, and, most recently, artificial intelligence “bots” that parse the meaning of management phrasing. All these provide plenty of information, but don’t accurately discern the actual risk associated with a particular investment.
Which brings us to the current investment environment.
When market dislocations occur (stepping on a “snake”, if you will) opportunities are presented to the active manager to provide clients with improved performance over the coming years. We sympathize with the angst clients endure as market forces shrink stock prices, but the chance to purchase more of a long‐term great business at a lower price is appetizing. The really great investments in an active manager’s career are borne from compounding gains over very long periods, and these gains can only be achieved by understanding the strength of a company and its associated sustainable competitive advantage.
Across all of our portfolios, we can point to investments held for the past five or ten years that have compounded our initial investment much faster than the overall market. There were times when these investments were “expensive” (when the current market price reasonably reflected an assessment of the future cash flow growth) at which time we defer allocating new capital to the existing holdings. However, there are also times when the “short‐ termism” of the market view – following a quarterly earnings shortfall, for example – creates opportunity to re‐ allocate new capital to further compound future returns.
Despite the angst, investors need to remember that, in a market dominated today by short‐term speculators, short term price performance really means nothing. Tough to do when the media is screaming the sky is falling. As their professional advisors, our communication should focus on the progress and risks associated with our various investments.
