Build a process to strike out superficially attractive investments

“If it looks too good to be true, it probably is” is not just sound advice when it comes to investment and finance in general – as the ‘sign-stealing’ scandal now enveloping the world of US baseball illustrates

04/02/2020

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

Seven years ago, if you had asked a stadium’s worth of US sports fans to name the worst team in Major League Baseball (MLB), the chances are they would all have given you the same answer. It was not so much a matter of opinion as stark fact: 2013 was the third consecutive season the Houston Astros – increasingly being dubbed the ‘Lastros’ – had lost more than 100 games.

Yet within a few years, the Astros had reached the very pinnacle of their sport, beating the LA Dodgers by four games to three to win the 2017 World Series. This remarkable change of fortunes apparently stemmed from the club’s use of an analytics system that aimed to enhance, through human evaluation and experience, the sort of complex statistical models with which ‘Moneyball’ proponent Billy Beane might have felt at home.

And yet it turns out there may have been more to it than that. Last November, this report by The Athletic alleged certain people connected with the Astros had engaged in ‘sign-stealing’ – a form of cheating in baseball that involves observing and decoding the signals the opposition catcher is giving his pitcher and then tipping off a batter in the hope it gives him a better chance of hitting the ball out of the park.

Reports suggest the club, which this month was fined the maximum possible $5m (£3.9m) and has fired both its manager and general manager, would focus a camera on the opposition catcher, relay the footage back to the clubhouse and, once the opposition’s signalling system had been decoded, would warn its batters what pitches to expect by the rather less technological means of someone banging on a trashcan.

It remains to be seen how much of the events of the last few months will feature in future editions of Astroball: The New Way to Win It All, Sports Illustrated journalist Ben Reiter’s in-depth account of Houston’s title-winning season and, in particular, the analytics system that had seemed to lie at the heart of the franchise’s new-found success.

As you might expect, it was that part of the book that had especially caught our eye, here on The Value Perspective, with a number of strategies that chime with how we approach investing. Prioritising process over outcomes? Tick. Making decisions today that risk making you look silly but should prove good in the long term? Tick. Using the power of data to inform decision-making? Tick.

Such ideas naturally appeal to us – creating, if you like, a strong narrative in our minds – but that is precisely why we also have a checklist (tick) of seven key questions we ask of every single company we consider as a potential investment. Set out in full below, these address the different aspects of any business we believe need to be checked and double-checked before we decide to part with any of our investors’ money.

The questions focus on areas such as the strength of a company’s balance sheet and the degree to which it converts its profits into cash. At heart, however, each question is designed to sense-check everything we do to ensure we do not fall victim to ‘narrative fallacy’ – that is, become sucked in by a story that initially appears to fit in well with our world view but where closer analysis will reveal all is not quite as it seems.

Baseball fans may have a different way to describe the idea but, in an investment context, that is a decent enough definition of a ‘value trap’ – an asset that appears undervalued but turns out to be cheap for a reason. Valuation – always valuation – is our central consideration because ultimately, as an investor, what you pay, not the growth you get, is the biggest driver of future returns.

Our seven ‘Red’ questions

  1. Has anything been missed off from the company’s enterprise value?
  2. Have profits – that is, the company’s net operating profit after tax – been misrepresented?
  3. Is the company’s past a good guide to its future?
  4. Do the company’s profits turn into cash?
  5. Is the company’s balance sheet good enough?
  6. Is the business itself good enough?
  7. Are there other risks to consider?

Source: The Value Perspective

Author

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst. 

Important Information:

The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.

They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

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