Please refer to Important Disclosure Information at the end of this research note.
Pattern matching is an important acquired skill in investment management.
Looking into our behavioral biases can sometimes reveal patterns that lead to suboptimal investment results.
We discussed some biases seen in retail investors in “Mr. Market – Manic-depressive or Consummate Salesman?”
Here we list some biases seen in professional money managers.
1. Searching for the obscure when the "grandma" trade will suffice
Five years ago, I worked at a hedge fund that (like most funds then) owned Apple. We owned Apple and my portfolio manager (PM) hated the fact that we did. To him, Apple was the ultimate “grandma” trade. He often said that clients weren’t paying us to own Apple which they could do themselves. Our job was to find great undiscovered stocks.
So the fund compromised by owning a relatively small 2% position in Apple and sold it a year later.
Let’s check the record: Apple shares traded at around $35 (split adjusted) then and trades at $115 now. That’s a 27% annual return over five years before dividends. Imagine if we had put 40% of our capital in this “grandma” trade as Buffett famously did with American Express shares and rode the shares all the way to its current share price.
2. Saying you like good businesses and then doubling down on commodities
Ever see a fund presentation where they claim to only buy “good businesses” with “strong cash flows” and then proceed to discuss a commodity stock?
Let’s be very clear: commodities are bad businesses. By definition, commodities lack pricing power.
So why do funds gravitate towards them? Is it because writing a compelling investment memo on a commodity stock is so easy and seductive?
Here’s how it’s usually done:
- The supply curve: Claim that supply is getting cut because the marginal suppliers are losing money and will stop production.
- The demand curve: Then using some industry data show that the demand will increase over the next 5-10 years.
- Prices: Voila! Price increase!
- Extra upside: Throw in a sprinkle of “upside” by claiming that your favorite company/stock will somehow be able to increase supplies without hurting prices to capture even more profits.
It’s a beautiful and repeatable investment recipe. The problem is, the thesis rarely works over a multi-year horizon. Recall the spectacular rise and fall of the rare-earths stocks?
Next time you see a quarterly investor letter where the portfolio manager (PM) pitches a commodity stock raise those eyebrows.
3. Style drift
You’ll know it when you see it.
If a “value” investor calls himself “opportunistic” and begins investing in speculative biotech or internet stocks, that’s one sign of style drift.
4. Digging in your heels even when the thesis is clearly wrong
I highlighted this bias as the “Consistency Principle” in “Mr. Market – Manic-depressive or Consummate Salesman?” and it bears repeating.
Don’t be surprised if you see many of these in this year’s September quarterly investor letters.
5. Closet chartists
Portfolio managers (PMs) were good analysts once. Then they got lazy and began delegating work to others. But the hubris remained.
They never completely trust the work done by their analysts and look for ways to confirm (or deny) the thesis.
There is no easier shortcut than looking at the charts. If the PM is selling down a stock because it’s declining and buying more if it’s rising, chances are he’s a closet chartist.
6. Too much emphasis on ‘reward’ and not enough on ‘downside risk’ and ‘probabilities’
A fund with a large analyst team is something like an open outcry auction floor. He who shouts the loudest gets to be heard. Or said another way, the investment ideas with the most compelling returns make it into the portfolio.
This creates a perverse incentive to focus only on the rewards and less on the risks and the probabilities, leading to sub-optimal position sizing. Any going concern (i.e., one that isn’t going bankrupt anytime soon) has a non-zero probability of becoming a multi badger stock. That's just the nature of the bell curve.
By understanding the downside risk and probabilities one can analytically size the position (invest 1% or 20% or zero). For more on this fascinating topic, I refer readers to our post “Building an Efficient Portfolio of Quality Stocks”
7. Creating busy work and too much diversification (“di-worsification”)
Funds with large teams are constantly researching and pitching new ideas to the portfolio manager (PM). A constant stream of new investments in the portfolio can look great for marketing purposes because it shows clients that the fund is working hard on their behalf.
Unfortunately, there are two perverse incentives at work here:
- Analysts who get paid for their winners and not penalized for their losers have an incentive to pitch as many ideas as possible.
- The PM has an incentive to buy new positions because it appears to justify his job to clients.
Unfortunately the PM rarely has the bandwidth or the deep knowledge to really vet the idea. Maybe the PM was a commodity investor and the idea is a technology idea.
So the PM compromises by buying a “toehold” position. Before you know it, the fund has ballooned into 100+ positions with no single position having any meaningful impact on the portfolio. Di-worsification anyone?
Don't discount the "grandma" trade
This brings us back full-circle. Identify those boring sleep-at-night stocks. Do the homework and bet big when the odds are in your favor.
Don’t discount the "grandma" trade!
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Burr Capital LLC), or any non-investment related content, made reference to directly or indirectly in this research will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this research serves as the receipt of, or as a substitute for, personalized investment advice from Burr Capital LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Burr Capital LLC is neither a law firm nor a certified public accounting firm and no portion of the research content should be construed as legal or accounting advice. A copy of Burr Capital LLC’s current written disclosure statement discussing our advisory services and fees is available for review upon request.