In honour of next Tuesday’s Melbourne Cup – the prestigious horse race famously held to bring Australia to a halt – let’s start with a quick trivia question:
In how many calendar years has the favourite finished first in each leg of Australian racing’s ‘Grand Slam’?
For the record, this four-legged achievement (in more ways than one) takes in the Golden Slipper, the Caulfield Cup, the Cox Plate and the Melbourne Cup.
10 years since the crash
While you ponder that, we will briefly travel back to the UK and the recent 10th anniversary of the moment most people had their first inkling all was not right with the global financial system.
On 13 September 2007, as we noted in A dangerous road, word began to spread that Northern Rock had sought emergency funding from the Bank of England, thus prompting the first run on a UK bank for more than a century.
The months that followed Northern Rock’s fall produced a barrage of negative press about the UK banking sector that only grew worse after the collapse of Lehman Brothers a year later – to the extent a major and persistent concern among investors was 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 really?
How likely is it that banks could go bust?
To explore the point further, let’s return to the world of horse-racing and our original question – and congratulations if you answered ‘None’.
You might well think it was not so improbable the quartet of horses the market considered the best hopes of winning Australia’s four big races might actually do so in the space of a calendar year but it has only ever come close to happening a handful of times.
Whenever a fêted sporting sequence is not achieved – the US and UK Triple Crowns would be two further examples from horse racing – people are surprised but should they be?
After all, if it were really that easy to win either Triple Crown, it would have happened on more than just a single instance in either country (the US in 2015) since the 1970s. And the answer to our opening question would not still be ‘None’.
Yet people become swept up in current events – be it horse races or financial crises – and grow ever more convinced something will happen even if history suggests it almost never does.
Be cautious around 'dead certs'
Michael Mauboussin, one of the great thinkers of value investing, has written on this subject a number of times. One such instance was on horse Big Brown who, despite being yet another ‘dead cert’, failed to land the third leg of the US Triple Crown in 2008.
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’.
The 'inside view' is 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’.
Most aquisitions won't perform as expected
One classic example he points to from the world of finance is the way company management teams 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 mutual fund manager does not.
In which case, you might reasonably ask, what makes us here on The Value Perspective believe we will outperform in the long run if the numbers suggest otherwise?
Why are we any different?
Well, every January we look to see what lessons we can learn from the previous year’s investments.
We analyse what we did right – and what we did 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. As such, 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 to keep you on the right side of the averages so that, instead of being caught out by your own emotions – how likely things feel at the time – you are in a position to exploit the emotions of others.