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Horse sense - Value investing is all about keeping investors on the right side of the averages

04/02/2013

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

In Two tribes, while discussing the different views the bond and equity markets appear to have of the banking sector, we noted how concerned many investors back in 2009 were that one of the big high-street banks could go bust. Yet, in the context of history, with Northern Rock the first banking insolvency in nearly 100 years, how likely was that?

To explore the point further, let’s switch to the world of horse-racing where one of the greatest feats is for a horse to win the ‘triple crown’. In the UK, this means winning the 2,000 guineas, the derby and the St Leger and just such a possibility was on the cards last September as Camelot, having already stormed the first two races, was the hot favourite to win the St Leger.

Adding the race to his year’s haul would make Camelot the first horse to win the Triple Crown since 1970 and the UK’s racing community seemed united in the belief this would happen. As it happens, this mirrored the conviction a few months earlier on the other side of the Atlantic that I’ll have another would be the first horse since 1978 to bag us racing’s version of the Triple Crown.

Having won the Kentucky derby and the Preakness stakes, however, I’ll have another – again the odds-on favourite – was withdrawn from last June’s Belmont stakes with a swollen tendon. Nor was Camelot destined to achieve his own piece of racing history as he was beaten into second place at the St Leger by 25-to-1 shot Encke.

Each time the racing world was stunned but should it have been? After all, if it were really that easy to win the Triple Crown, it presumably would not last have happened in each country back in the 1970s. However, people become swept up in current events – be it horse races or financial crises – and grow more and more convinced something will happen even though history suggests it almost never does.

Michael Mauboussin, one of the great thinkers of value investing, has written on this subject on a number of occasions – including in the context of Big Brown who, despite being yet another ‘dead cert’, failed to land the third leg of the us Triple Crown in 2008 after finishing last to a 38-1 long-shot.

Mauboussin has argued the failure of most people to consider how successful other horses had been when they were in Big Brown’s position illustrates a bias among human beings for the ‘inside view’ – making predictions based on a narrow set of inputs, which may include anecdotal evidence and misperceptions – as opposed to the broader, more fact-oriented ‘outside view’.

One classic financial example he points to is the way company managements are always convinced any acquisition they are planning will add value even though history suggests some two-thirds of all such deals do not make the hoped-for return – and nor should fund managers believe they are immune .

After all, every professional investor is convinced they will outperform their benchmark index even though the cold statistics show that, over three years, the average unit trust fund manager does not. In which case, you might reasonably ask, what makes us here on the value perspective believe that we will outperform in the long run if the numbers suggest otherwise?

Well, every January we look to see what lessons we can learn from the previous year. We analyse what we did right and wrong in our portfolios and, while the great majority of people would say that all comes down to what made and lost us money, the great majority of people would be completely wrong.

For us, the right lesson to take from the process is, if I took a particular decision 100 times, would I make money on average? As value investors, we want to make investments that make us money 60 or 70 times out of 100 so, if a particular course of action turns out to have been one of the times we lose money, the lesson is not ‘never do that again’ but ‘just keep doing it – over and over and over’.

That, in essence, is what value investing is – a set of rules that helps keep you on the right side of the averages so that, instead of being caught out by the your own emotions – how likely things feel at the time – you are in a position to exploit the emotions of others.

 

Author

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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