Monthly Commentaries

The Head and the Heart

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We have contended for some time that clients are best served owning small cap investments equally proportionate to traditional large cap investments. Investors, on the other hand, tend to perceive small cap investing as a volatile group, based on the actions of both a poorly constructed index and a group of poorly designed products. This month we delve into those perceptions, where they may come from, and discuss a particular manager whose considerable track record illustrates the strength of fundamental equity analysis.

“Isn’t that the good life is a simple one, Sittin’ in the yard watchin’ the leaves go by; Reading good books and playing songs, Watching the wind blow through your front yard; Don’t follow your head, Follow your heart…”

from Heaven Go Easy on Me, Head and the Heart

I’m a big fan of the folk‐rock band, Head and the Heart. Been to their concerts and listen to their music all the time. But that’s not really the purpose of today’s comment.

Our business is now just over four years old and, in that time, we’ve been fortunate to have clients award us with almost $600 million to manage. During that time ‐ and over the numerous years before ‐ I’ve had many people tell me that small cap investing is too volatile. They look at the Canadian small cap indices and its concentration of volatile, commodity‐based companies (over 50% of the index weight, at last count). They look at the universe of providers, and note that most either adhere to index construction or employ some form of price momentum strategy that increases trading cost and volatility.

Many investors consider a number of these factors – and their heads are certain that small cap investing in Canada isn’t worth pursuing.

In his fascinating book, On Being Certain, neurologist Robert Burton systematically and convincingly shows that certainty is a mental state, a feeling like anger or pride thatcan prove useful at times, but that doesn’t dependably reflect anything like objective truth. One disconcerting finding he describes is that, from a neurocognitive point of view, our feelings of certainty about things we’re right about is largely indistinguishable from our feelings of certainty about things we’re wrong about.

A friend of mine has a great phrase – “seldom right, but never in doubt” (a reference my wife also employs to describe yours truly). This is a truism about humans. We’re as sure of the future as we are that 1+1=2. However, mathematics employs deductive reasoning wherein one begins with an accepted premise and moves toward a conclusion based on previously “known” information to arrive at a correct answer with certainty.

Conversely, all of the universe is an open system subject to inductive reasoning ‐ while the conclusion of a deductive argument is certain, the conclusion of an inductive argument may be merely probable, based upon the evidence given. Nasim Taleb wrote an entire book on the theory. “If I have seen a million swans over my lifetime and all of them were white, I might conclude that all swans are white. But I would be wrong, as black swans reside in Australia.”

Taking this one step further, Michael Mauboussin’s argument on the luck‐skill continuum aptly reflects the reticence shown to Canadian small caps. He contends that activities shaped by luck – such as stock market forecasting – are harder to predict and, therefore, less accurate. If an activity is mostly skill – such as fundamental analysis – the probability of accuracy and consistency is quite high.

There are a few black swans in the small cap investment circle. The standout, if for no other reason than for their consistency and reliable return, would be Mawer Investment Management’s New Canada fund. If you were fortunate enough to have invested in that fund for the past ten years, your return would have exceeded 11.5% net of fees compounded to June 30, 2018 (based on Globefund information). That means you would have roughly tripled your investment over the period.

Comparatively, the S&P/TSX Composite return was 4.24% for the same period – that same $1000 would be worth slightly more than half what your Mawer investment would be worth. Even more interesting, Mawer’s small cap strategy outperformed their own Canadian equity strategy over the same ten‐year period by over 3% compounded annually!

The lack of correlation between a good, fundamental small cap strategy and a large cap strategy, combined with the long‐term performance contrast, should appeal to every investor. Understanding the methodology of a quality‐oriented investor like Mawer will definitely appeal to any investors heart. To reiterate the words of our folk rockers, follow your heart.