The paradox of investing - Why the professionals usually get it wrong

There has been much media coverage recently about the excessive charges levied by asset managers that are able to enjoy profit margins of almost 40%, which is among the highest of publicly quoted companies. The damning report by the Financial Conduct Authority, which was published last month, concluded that not only were charges too high but that performance of the average fund was disappointing and often underperformed the main stock market indices.

To the lay investor, how can the professionals get it so consistently wrong and what is the alternative to committing one’s savings to funds with sub-index returns and paying high fees for the privilege?

Seeking the advice of experts

The savings and investment industry is complex and it is only natural that people should choose to seek the advice of experienced experts. After all, if you wanted to improve your golf game or needed complex keyhole surgery you would consult a golf professional or experienced surgeon confident in the knowledge that they would provide a level of service that required years of training and practice.

However, although asset managers and stockbrokers also have years of qualification before acting on behalf of clients, the results are very different. Fund managers often underperform their benchmark and stock broker analysts recommend, appropriately for this time of year, many turkeys!

The reason for the poor returns offered by professionals is not through lack of effort and hard work. On the contrary, the hours worked in the City are long and arduous and many of the analysts know the companies they are researching better than their own management.

The challenge facing all investors is that because the stock market is so efficient it is extremely difficult to outperform it on a consistent basis. The great value investor, Benjamin Graham, nicknamed the index ‘Mr Market’ and paid it the utmost respect knowing how difficult the market was to beat. Certainly something an investor will require to obtain above average returns is patience which is an attribute that is often not available to fund managers and analysts who are judged and remunerated on short time frames of as little as 3 months.

How the market reacts to major events

To understand how the stock market works it is necessary to think of it as a discounting mechanism that efficiently takes into account all available information and prices it accordingly (known as the Efficient Markets Hypothesis).

For instance, why did the market not fall after the recent Italian referendum, which raised the prospect of an extreme right wing party being elected that is in favour of leaving the EU as well as the possible collapse of the country’s banking system? The reason is that the result of the referendum was largely expected (i.e. discounted already) and the EU, ECB and Italian government have collectively been pro-active in forming a strategy that will avoid a banking collapse that could de-stabilise the EU’s financial system.

Even more surprising was the market response to the election of President-elect Trump in the US, which was widely expected to cause a heavy sell-off in risk assets, such as equities. However, stock prices barely blinked before the market was making new all-time highs.

Unlike the Italian Referendum, the election of Donald Trump was not foreseen but the market quickly concluded that the world had not caved in and Trump’s proposed economic policies could benefit the US because of the fiscal stimulus that he is promising. Most brokers and asset managers were expecting a fall in equities and a rise in bonds (as a safe haven) if Trump was elected. The reverse has proved to be the case, with a surge in stocks and such a large fall in government bond prices that it could herald the end of the bull market in fixed interest securities that began in the early 1980’s.

Even the fall in the stock market following Brexit proved to be short lived. Despite all the gloomy prognostications from economists and think-tanks the economy has proved resilient thus far and the stock market has continued to grind higher in the face of ‘bad news’.

The challenges of good stock-picking

The market reaction to the unexpected results at the polls in 2016 shows how difficult it is to second guess the market and the same also applies to picking individual stocks. The best performing stocks in 2016 have been the commodity sectors, miners and oils, and yet there were not many ‘experts’ recommending them at the beginning of the year.

After a prolonged period of underperformance many asset managers were significantly underweight in commodity shares at the beginning of 2016. One of the reasons they have done so well is because funds have been forced to buy into the rise to prevent further underperformance.

For stock broking analysts, the same psychology has been evident. Increasingly in recent weeks, market reports of the previous day’s trading include comments such as ‘UBS today upgraded Rio Tinto to outperform from neutral’ (December 7th) or ‘Morgan Stanley upgraded HSBC to equal weight from underweight and raised its price target to 645p’ (December 6th). For the latter recommendation, the share price of HSBC has risen by almost 60% since mid-June and at 675p is already well past Morgan Stanley’s target!

As stated earlier, it is not that the asset managers or stock broker analysts misunderstand the company or have produced research that is full of ill-conceived analysis. Apart from the fact it is very difficult, and rare, to outperform on a consistent basis, a major obstacle for City professionals is that they operate in an environment that militates against good stock-picking.

As in many walks of modern life, we demand instant gratification. The emphasis on short term performance means that decisions are made that are frequently a response to the change in the share price rather than the fundamental values of the stock under review.

Perils of hiding behind a benchmark

Much decision making can be explained by behavioural analysis (Stockopedia references the excellent James Montier in this area of investing). The relentless rise of commodity shares and, more recently, bank stocks has caused so much pain to the performance and reputation of asset managers and analysts that they have been forced to capitulate - one of the behavioural traits of investors that should be avoided.

Often, positions in stocks are initiated or increased just to reduce an underweight or to neutralise a holding against the index weighting. Managers can take comfort that their performance will be judged on a relative basis (i.e. against other asset managers and the index) and not an absolute basis meaning how much money is made or lost irrespective of the market and other asset managers.

Hiding behind a benchmark or index leads to non-conviction and defensive investing whereas the most successful investors are prepared to continue backing their fundamental research, despite the movement in the share price or the index.

The most famous investor alive today, Warren Buffett, is a prime example of a conviction investor who has managed to produce consistent out-performance. What is so remarkable about his track record is that the huge size of the funds under management at his company, Berkshire Hathaway, makes it much more difficult for him to trade in a size that is likely to have a meaningful effect on the performance of the fund. That is not to say he has not endured periods of underperformance but he has had the courage and belief to follow his investment tenets when the market and stock prices may have been suggesting otherwise.

The most infamous bubble in recent times was the technology boom at the end of the 1990’s which can be compared to the tulip mania of 17th century Holland and the South Sea bubble of 1720. Buffett did not chase the sharply rising share prices and was later vindicated. The valuations for technology companies reached such stratospheric levels that normal valuation yardsticks such as PEs or dividend yields were rendered irrelevant.

To this end, new valuation methods were used to justify the rocketing share prices. These included DCF (discounted cash flow) analysis whereby future cash flows over many years in the future were discounted back to produce a present day valuation that was sufficiently ahead of the current share price for analyst to be able to recommend it. Another valuation metric which became popular was EBIT (earnings before interest and tax) which Buffett cynically christened ‘earnings before interesting things’.

What the technology bubble illustrates is how irrational professional investor behaviour can be and that, occasionally, even the stock market can become inefficient, which creates opportunities for the more patient and less emotional investor.

No surprise that big funds underperform

The success of Buffett is very much the exception and not the norm for funds with so much money under management. It is a self-evident fact that the large funds are a proxy for the market itself as they represent most of the quoted shares in issuance. Taking into account the costs of dealing and administration on top of charges it is not surprising that the majority of funds underperform the index after expenses.

This partly explains the growing popularity of index funds which attract lower charges and are guaranteed to produce returns close the benchmark they are shadowing. Most of the bigger funds also have a significant bias to larger companies and in the UK the index is top heavy in mega-cap companies. For instance, Royal Dutch Shell is over 7.5% and HSBC more than 5% of the FTSE All Share Index (which includes the FTSE 100, 350 and Small Cap). The market capitalisation of Shell and HSBC are both more than double the total of the aggregate of all the companies in the FTSE Small Cap Index! This means that if an asset manager is significantly underweight in the largest quoted companies it will quickly have a major impact on performance of the fund.

Advantages for the individual investor

The advantage for the private investor is that he or she can disregard what the index is doing. The successful private investor, John Lee, said that the two main attributes for successful investing are patience and common sense and it is easier for an individual to deploy these two virtues than for an asset manager.

As most private investors will not be dealing in millions or multiple thousands of pounds it allows them to invest more easily in smaller illiquid (the shares are only available to deal in relatively small size) companies. Smaller companies have the major advantage that they are relatively under-researched and therefore less efficiently priced than large stocks. Many of the better performing funds specialise in areas such as small companies or a less popular geographical region or industry. This is partly explained by the lack of peer pressure from competing funds and the absence of a well know benchmark index that imposes the tyranny of short term performance on managers.

A final quote from Warren Buffett: ‘’sloth is the cornerstone of our investment style’’. This is only partly a tongue in cheek comment and is directed at the investment managers and analysts who are continually flip-flopping with their funds and recommendations for the reasons discussed above. However, by being patient and looking through the short-term noise in the market while applying fundamental analysis with strong convictions it is still possible to produce well above average returns.