In most things in life, if your answer is correct, you score points or win the prize. Not in investing, where not only must you be correct, but your correct call must also be non-consensus. That is, you must be right and prove others wrong. To achieve exceptional results, you must do something that makes you stand apart from the rest.
Standing apart means you opt for the lonely trade, not the crowded trade. Markets do not reward copycat research that leads to consensus conclusions that are already built into the current stock price. They reward differentiated research that results in the discovery of a new and correct fair price that restores market efficiency.
This chapter also describes how going passive is not a panacea and in fact may prove to be a problem. It includes an exposé on gimmicky marketing strategies masquerading as genuine investment strategies and how you can distinguish between the two.
Think Different, Be Right, and Prove Everyone Else Wrong
Active investing is a tough vocation in which losers can easily outnumber winners. In this chapter, I will address why winning (beating the market) is so uncommon and how you can improve the odds. The solution is simple but not straightforward, because not only are the rules of engagement different, they are asymmetric.
In most situations in life, a correct answer usually implies success. Not in investing, where even if you are correct, you may not make any money. To succeed, not only must you be right, you must prove everyone else wrong. That kind of asymmetry can be tough to understand, let alone accept, so let us take a deeper look.
“In investing not only must you be right, you must prove everyone else wrong.”
Research Analyst or Regurgitation Analyst?
Imagine you are an analyst researching a company. With painstaking precision, you estimate how much money that company is going to make in a given quarter or year. When the numbers come in and they match your expectations, you feel pleased with yourself—you were right. But if everyone else came to the same conclusion, you will not make any money because those expectations were already priced into the stock.
Let us say you are researching Clorox and conclude that it is a company that makes high-quality bleaching products and charges a premium over store brands. Few people would disagree, but neither would they learn anything new—and therein lies the problem. If research does not uncover anything original or differentiated, it is not value-added research but simply regurgitation, the investment equivalent of reinventing the wheel.
On the other hand, if I told you that Tim Hortons in Canada makes high-quality coffee using a more expensive blend of 100 percent Arabica beans, yet sells it at a low price that appeals to frugal Canadians, it would qualify as differentiated research if you did not already know this.1
Markets do not reward research that discovers or proves what others have already discovered or proven. All the midnight oil burnt; frequent flyer miles logged; and arduous meetings with management, suppliers, customers, and competitors to conduct fundamental research amounts to zilch if you do not uncover anything new or different. Active investors who are unskilled in their research efforts are rightly facing an existential wake-up call: differentiate or die. It is not a market conspiracy but a market objective to weed out such undifferentiated active investors who add transaction costs in the form of high fees for their efforts but generate no value.
The Asymmetry: Penalty Points
Being correct is hard enough in markets; being correct and non-consensus is harder still. But it gets worse. Just when you thought you understood the rules of the game, markets throw you another curveball. In your imaginary life as a research analyst, let us say you concluded that the company you were studying would make more money than the consensus estimated, and you valued it accordingly. If that does not happen, it is you who will be proven wrong, instead of the consensus, and you will end up losing money. This is because incorrect answers result in price distortion and market inefficiency, and to discourage such activity, markets impose penalties (losses) on such participants. This is what makes investing not simply different but asymmetric. You may not make any money for being correct if your correct views are consensus, but you will lose money for being incorrect. Figure 4.1 depicts this asymmetry:
Here are some examples:
1. Correct but consensus call: Disney. A great company, but most people agreed. Unsurprisingly, the stock has traded in a narrow range between 2015 and 2018, proving that even when a call is correct, if it is also the consensus view, there is no significant mispricing to arbitrage or money to be made.
2. Correct non-consensus call: Ahold Delhaize. I regarded this food retailer with stores in Netherlands (Albert Heijn) and the United States (Stop & Shop, Giants, Hannaford, and Food Lion, as well as Peapod) as a well-managed company with good profit-growth potential. However, most investors were skeptical, valuing it as an ex-growth company with unstable earnings. When that consensus view was proven wrong, the stock doubled, from around €11 in 2012 to €22 in 2018.
3. Incorrect non-consensus call: Pitney Bowes. This was literally a money-minting business because it had near-exclusive rights from the U.S. Post Office to print digital stamps. As a quasi-monopolistic business, it made eye-popping profits and returns on capital invested. Correct research would have led to the conclusion that these high returns would not last. Anyone who thought otherwise would lose money: the stock fell by 66 percent, from $28 in 2014 to under $7 in 2018. Sadly, I was among those investors. I made this mistake earlier in the mid-2000s when I bought Pitney Bowes’s European counterpart, Neopost. Its lucrative profit margins and cheap valuation metrics (low PE and 5 percent dividend yield) seduced me into thinking I had found an investment bargain. But those numbers proved illusory when digital disruption came along: the profits collapsed and, along with them, the dividends that I had counted on. I lost money (penalty points for my incorrect albeit non-consensus call) and some sleep, but I also recognized that every mistake can be a learning opportunity.
FIGURE 4.1 Asymmetric payoff of being correct or incorrect
What I learned was that to find a treasure instead of a trap, an investor must first be a business analyst and then a financial analyst. If you do not understand the business (and what can go right or wrong in it), your numbers will be wrong no matter how detailed your spreadsheet or precise your estimates (more on this in chapter 7, “False Positives and Negatives”).
“To find a treasure instead of a trap, an investor must first be a business analyst and then a financial analyst.”
If undifferentiated or incorrect active investing is not the recipe for success, is investing passively the winning strategy? Not necessarily. The answer depends on what the markets want, not what investors want.
Markets Want and Reward “Fair Price Discovery”
Just as nature has a singular and simple endgame—to reproduce—markets also have a singular and simple endgame—to uncover the fair price for an asset. Fair-price discovery is just another name for uncovering the correct intrinsic value of a business. It serves as a mechanism of exchange through which an asset can be converted into cash, or vice versa, at a price where neither side profits or loses.
“Fair price discovery is just another name for uncovering the correct intrinsic value of a business.”
The more it comprises stocks that are fairly valued, as opposed to under or overvalued, the more efficient the market becomes—and vice versa. In inefficient markets, the side that is correct and non-consensus will profit from the side that is not. This is the market’s way of encouraging us to express and challenge different points of views: we will ultimately arrive at the fair price, which restores efficiency.
Markets do not play favorites. Anyone can take part and earn rewards if they give the market what it is trying to solve for: fair-price discovery. Markets do not care if they achieve efficiency on the shoulders of a man or a woman, bottom-up investors or top-down, growth or value, quant or fundamental, active or passive. All are means to an end. This explains why many distinctive styles of investing can coexist in a market, so long as they serve the market’s purpose of discovering fair prices and restoring efficiency.
Markets Do Not Want “Price Distortion”
On the flip side, markets severely penalize participants or strategies that perpetuate price distortion, because not only do they not create efficiency, they contribute to market inefficiency. The market does everything it can to sabotage such efforts, if not initially then eventually. Price-distorting participants and strategies find themselves exposed to a massive accumulation of penalty points (losses) smashing together like a massive car pileup on a crowded expressway.
I think of strategies that do not contribute to fair-price discovery (market efficiency) as “gimmicky” asset-gathering or “sham” strategies, while those that do are “genuine” investment strategies. I believe it is important for investors to invest in “genuine” investment strategies that are likely to contribute to market efficiency in the long run, and avoid slick asset gathering strategies that do not.
Asset-gatherers tend to package gimmicky investment concepts to pander to the desires of investors but are usually not in their best interests. “Sham” strategies often appear to generate good returns for a period of time, but winning a battle should not delude you into thinking you will win the war. Their superior performance could be short-lived. Let me show you how these strategies initially work but eventually fail.
Markets need diversity of participants and views to discover the fair price, and to encourage that, they will reward each participant just enough to keep them in the game. To the naïve observer, such occasional, sporadic successes will masquerade as a “proven” way to make money forever, but eventually they will prove to be illusory and temporary. This is because many “sham” strategies work as self-fulfilling prophecies. If enough people believe something—whether it is true or not—a stock or a market can go up, until reality sets in and investors realize that the emperor has no clothes. Here is a typical cycle: A particular stock (or cluster of stocks) will appear on screens as superficially attractive, so some active money will buy in, causing its price to rise. If some persistence develops, momentum will kick in, and quant strategies will put money to work. The stock will soon attract the trend-following crowd, who add their weight to the scale, thereby perpetuating the illusion that the “sham” strategy is working. If there is a seductive story line and some heady growth rates to boot, growth investors will jump in. If the story line is broad enough to package as a theme such as “a super-cycle in commodities” or “cloud computing” or “internet of things,” thematic investors, smart beta, and the rest will join the party. By this time, the bandwagon of participants has turned the strategy into a money-spinning formula that everyone wants, no questions asked. The price of the stock keeps rising. Passive will throw even more money in at any price, because its job is not to ask but to invest.
Note that nobody in this gravy train questions whether their activity results in price discovery or price distortion. Is the stock trading above, at, or below its intrinsic value? Everyone blithely skips that part. Quant doesn’t calculate it (“algorithms compute relative value not intrinsic value”), trend followers don’t care about it (“don’t let facts get in the way of a good momentum story”), growth investors rationalize it (“the high growth assumptions justify it”), and passive ignores it (“theirs not to question why, theirs but to do or die”).
By this time, so many participants have piled onto the same stock or group of stocks or sector or theme that it becomes a very crowded trade, with few if any contrarian views to supply a counterbalance. Crowded trades are a form of complacency and herding, which are anathema to the market’s goal of fair-price discovery. The market notices this lack of diversity and smacks it with a reality check. It starts testing the crowd with some mood swings or volatility, which quickly rattles the weakest players. Momentum starts to reverse course, and the trade begins to unravel. First the trend followers bail, then the quants exit, soon growth investors take cover, and finally passive investors, the last ones out, lose their shirt trying to get out of positions where there are few takers.
Do Not Fall for the Slogans, Scrutinize the Substance: Real or Fake?
You hear so many pitches backed by compelling data and catchy slogans, it can be confusing to figure out what is real and what is fake. Too many investment-management firms have found it more lucrative to become good asset gatherers than good asset managers. In their quest for gathering assets, as a marketing ploy, they spew out “gimmicky” strategies as “genuine” investment strategies.
You (or your investment adviser) must learn to recognize the difference. If the goal of the strategy is to offer, say, low volatility or autonomous driving exposure, this is all fine, so long as you understand what is happening. All these offerings in my view are asset-gathering strategies, not investment strategies. They are designed for what investors want, not what markets need. As an investor you might think, well, what is wrong with that—as long as my wants are met, why should I care about the market’s needs? The problem is that what markets do not need, they will not reward. If your wants do not align with what markets want, your investment is unlikely to generate appropriate rewards; on the contrary, it could expose you to more costs and risks.
When you unpack the pitch, you will find that gimmicky asset gathering strategies spun as “genuine” investment strategies are usually a solution in search of a problem. Like a pill for an imaginary illness, you are paying for something you think you want but your body does not need.
Let us say you want a makeover or a massage. It makes you feel better, but your body does not need it and is not going to reward you for it. On the other hand, if you give the body what it really needs—exercise—it will reward you for it. Just as makeup does not make you beautiful and a massage does not make your body fit, buying into “sham” asset-gathering strategies offers a superficial, temporary, feel-good boost, not a real improvement to your financial health.
For example, between 2010 and 2013, it became easy to market “low-volatility” strategies because they were pitched as low risk and met investors’ desire for stability, after the traumatic market crash of 2008–09. But what happened? Instead of low risk, all they ended up delivering was low returns. They underperformed the broader benchmarks because they owned stocks in the less volatile but more expensive consumer-staple sector (markets penalize overvaluation, or price distortion, with losses or underperformance).
Asset-gathering strategies take advantage of your fears and vulnerabilities and package them as investment strategies that meet your wants. Like a child’s security blanket, it feels very soothing, but it is not in your best interest to hold onto. Wean yourself off it and teach yourself to deal with the ups and downs of a genuine investment strategy. “Genuine” investment strategies may lose the battle but tend to win the war while the opposite is generally true of “sham” strategies.
Passive Investing
Passive implies investing in a widely followed benchmark to secure exposure to a country, sector, theme, region, and/or factor. Typical examples are the S&P 500, the Nikkei 300, or the FTSE Global 100. These tend to be market-capitalization weighted (meaning that the composite companies tend to be large ones), and their constituents change relatively infrequently.
Because far less effort is required to construct and maintain a benchmark, it can be offered at lower cost compared to actively managed strategies, which entail a great deal of effort and higher costs. Passive indices tend to focus on factors such as size, free float, traded liquidity, broad representation, and the like. Given their desire for infrequent change, they tend not to account for fundamental attributes that fluctuate, such as dividend yields or debt-service ratios. Passive is more concerned about breadth and depth of market exposure and less focused on valuation or balance-sheet metrics.
The passive approach appeals to those who do not mind letting others decide which stocks to invest in and getting broad instead of curated market exposure, in exchange for low fees.
Passive = Prisoner’s Dilemma
Passive investing is a prisoner’s dilemma. A paradox in optimal decision-making, the prisoner’s dilemma describes a circumstance in which two otherwise rational people act in their own self-interest and end up worse off than if they had cooperated.2 Both sides start with a logical argument: if markets are efficient, it makes sense to access them at low cost. But passive investors operate by riding on the coattails of active investors, who perform the arduous task of assessing fair prices. If others follow the same logic, over time markets become inefficient, an inferior outcome for everyone.
In a market dominated by passive investors, investing becomes reflexive, driven by flows instead of fundamentals. Without the counterbalance of active, passive tends to become a victim of its own success: more money managed passively means more price distortion—which the market penalizes with losses. The Achilles heel of passive is that, like undifferentiated active, it does not further the market’s endgame of fair-price discovery. In fact, passive gets a free ride off the work of correct, contrarian active investors. And just as markets do not reward reinventing the wheel (undifferentiated or incorrect active investing), they do not reward free riding (passive) either!
The Passive Bandwagon: Panacea or Problem?
Keep in mind that for the bulk of the assets under management, passive does not actually transact in the securities it owns, it simply marks them to market. In a period of increasing inflows, managers of passive funds bid up prices without regard to whether they are overpaying. If these funds were to face large redemptions and outflows (which as of December 2018 has not happened in a decade), it would find few, if any, active buyers because the latter have dramatically shrunk in size. The larger the gap between the market price and the fair value, the greater the loss passive will have to incur to find a natural active buyer to take the other side of the trade.
In fact, this is exactly what happened in the late 1990s, when clients berated their active managers for their underperformance against the Nasdaq for several years in a row. As the years rolled by and active managers continued to underperform in a strong up market, investors did what they often do—top ticked a trend (bought at the highs). In 1999–2000, many clients withdrew money from their active managers and plowed it into passive by investing in vehicles such as the QQQs (an ETF which mimicked the movements of the Nasdaq 100), which had doubled. That decision came back to bite when the market momentum brutally reversed and popular indices such as the Nasdaq 100 fell from a peak of 4,500 in March 2000 to a trough of below 1,000 in late 2002, causing a whopping loss of 78 percent; see figure 4.2.
FIGURE 4.2 Index Performance: Nasdaq 100, 1/1/1997–11/1/2002. Source: Thomson Reuters.
To put this arithmetic in dollars and cents, if you had put a million dollars in the QQQ ETF in early 2000, three years later you would have lost $780,000, and your nest egg would have shrunk to $220,000. To add insult to injury, in the aftermath of the tech wreck, most active managers handsomely beat the benchmarks and regained the upper hand in both performance and inflows. For instance, if you had invested that same money in U.S. large-cap-blend actively managed strategies,3 you would be down only about 27.2 percent, and your portfolio would be worth $728,000. That is a difference of half a million dollars!
What the Wise Do in the Beginning, Fools Do in the End
It should be clear by now that passive can only deliver on its promise of positive returns at low cost when active predominates and is able to do its job of calibrating fair prices. Of late, however, the opposite is happening—passive is dominating. With that dominance comes the risk of owning overvalued stocks and contributing to price distortion and market inefficiency. I suspect a déjà vu of the Nasdaq 2000–2002 crash in milder form is in the cards. Investors are confusing early success with lasting success, and coincidental success with inevitable success.
The early bird in passive caught the fish, but that attracted too many birds all going after a finite number of fish. These latecomers are unlikely to repeat that early success. When too much money chases too few goods, it bids prices up simply through technical demand/supply imbalances, not fundamental factors. When markets experience an extended or pronounced correction, investors with lemming-like blind faith in passive could be exposed to three painful lessons:
1. Markets do not reward free riding.
2. Markets penalize price distortion.
3. Lemmings tend to reach their demise instead of their destination.
Active: Pronouncement of Dead Man Walking Is Dead Wrong
It is a perennial debate: Should we take the safe route and stick with investments that mirror the stock market itself, relying on standard indexes like the S&P 500? Or do we attempt to do better than the market, using fundamental research to help us find mispriced stocks? The first approach is called passive; the second, active. I am an active manager—something that is not in vogue of late.
Prevailing wisdom would have you believe that active investing has an inferior track record and poor reputation; it is simply not possible, goes the claim, to beat the market. I beg to differ. Active investing, practiced correctly, can deliver outperformance. Not only can it do so, but it has already done so.
A paper published in the Financial Analysts Journal in 2017 concludes that there is no evidence of underperformance among a group of funds with a high active share4 (those whose holdings differ substantially from their benchmark). Indeed, those who are also patient (with holding durations of more than two years) have outperformed, on average, by more than 2 percent per year. Earlier studies showed similar results.5
It is clear that the headline drumbeat of underperformance by active is misleading as the devil is in the details. A closer examination of these studies reveals that the biggest underperformers were those who claimed to be managing actively but were not. The underperformers fell into two categories: closet indexers (benchmark huggers who called themselves active but were not) and pseudo active (those with a low active share between 60 and 80 percent who pretended to be active but were not). It was these two types of faux active practitioners who diluted the overall performance record of all active managers. The same studies showed that truly active managers (those with an active share over 80) beat their peers and passive by 2.41 percent per annum on a gross basis. (Obviously, fees would reduce this, but it is uncommon for the fees of an active manager to exceed say 1 percent, so even after deducting such a fee, the net performance would exceed the relevant benchmark’s returns.) When you look underneath the covers, there is a very compelling difference and argument in favor of truly active and against pseudo or closet active, not all active.
The results found by these studies fit the ideas in this chapter. Truly active managers contribute to fair-price discovery and deserve to get rewarded by markets with excess returns—and they have been. Those who did not manage actively (but marketed themselves as if they were), as well as those who managed naïvely with little differentiation or skill, were destined to fail—and did.
Markets Do Not Care for Your Wants, They Care for Their Needs
Remember that markets rule and referee, while investors merely express their views (with their money). If you indulge in your wants at the expense of the market’s, you are on the losing side and get penalized. If you serve the market’s needs, you are on the winning side and get rewarded. The smart move is to align yourself with what the market needs—an investment approach that leads to fair-price discovery and reduces price distortions. This is exactly what non-consensus investing strives to do, and in performing this double duty, it gets a shot at being doubly rewarded with above average returns. I call these returns “upset victories” in investing. They are the topic of the next chapter.
Top Takeaways
1. Investing is unlike any other field: not only are the rules of engagement different, they are asymmetric. If your views are consensus, you may not score any points for being correct, but you will incur penalty points for being incorrect.
2. Markets reward differentiated research that not only proves you are right but also proves the consensus wrong.
3. Markets reward efforts that lead to fair-price discovery and penalize those that lead to price distortion. Markets do not reward free riding nor price affirmation, which is the investment equivalent of reinventing the wheel.
4. Strategies that do not contribute to fair-price discovery are sham strategies, not investment strategies. Asset-gathering strategies serve the false wants of investors, not the true needs of markets. Markets do not reward what they do not need.
5. Non-consensus investing aligns itself with what the market wants and incentivizes: diversity of views contributing to fair-price discovery and less price distortion. For performing this double duty, non-consensus investing gets a shot at being doubly rewarded.
6. Passive is a prisoner’s dilemma. When everyone goes for it, all are worse off, not better off.
7. Studies show that truly active managers with a high active share have outperformed their peers and passive indices, even after fees and expenses. Non-consensus investing is a truly active way of investing, designed to beat a benchmark, not match it.
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1. This research proved doubly rewarding. Not only did I uncover a profitable investment opportunity with an “and” proposition of a quality product and value pricing, I also discovered Timbits, mini donuts sold at Tim Hortons that are decadently delicious.
2. Why is it called the prisoner’s dilemma? The basic concept was first delineated in 1950 by two mathematicians. Soon after, a Princeton math professor named Albert Tucker created a famously memorable scenario that makes the idea crystal clear. The scenario goes like this: Barry and Frank, arrested for breaking into a warehouse, are being interrogated in separate rooms. Both are offered the same two choices: If you confess that the other guy did it, he’ll go to jail and you can go free. But if both keep quiet, both get a reduced charge and considerably less jail time. Self-interest would have Barry and Frank taking the first choice—but then which one gets to go free? The only way both guys get the best deal (the least jail time) is if each one trusts the other to think cooperatively.
3. See Hartford Funds, “The Cyclical Nature of Active and Passive Investing,” https://www.hartfordfunds.com/dam/en/docs/pub/whitepapers/WP287.pdf. Skeptics might refute this example as comparing two different benchmarks. I disagree. Active managers deliberately avoided expensive tech stocks that dominated the Nasdaq 100 Index and actively invested in other sectors of the U.S. market within their broader U.S. large-cap-blend mandates; so the comparisons and conclusions are valid from that standpoint.
4. Active share is a measure of the percentage of stock holdings in a manager’s portfolio that differ from the benchmark index. Studies have shown it is a key predictor of a manager’s performance potential. The larger that share, the greater the differentiation. Below 60 percent is considered no differentiation, or “closet indexers”; between 60 and 80 percent is considered mild differentiation, or “pseudo” active; and over 80 percent is viewed as very different from the benchmark, or “truly” active. Throughout my investment career, the active share of portfolios I managed has typically exceeded 80 percent, which is why I view myself as a truly active manager and non-consensus investing as a truly actively managed investment approach.
5. Martijn Cremers, “Active Share and the Three Pillars of Active Management: Skill, Conviction and Opportunity,” Financial Analysts Journal 73, no. 2 (2017): 61–79; Martijn Cremers and Ankur Pareek, “Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently,” Journal of Financial Economics 122 (2016): 288–306; and Antti Petajisto, “Active Share and Mutual Fund Performance,” Financial Analysts Journal 69, no. 4 (2013): 73–93.