The context – no place for hubris nor for the blame game…
Never forget investment is a probabilistic endeavour, not a world in which the future is certain. We will make mistakes, it is a statistical certainty, and acknowledging this creates the important emotional space that allows us to face up to what’s happened. We can be honest with ourselves and our clients as we do not claim to have an infallible process, just one that leans the statistics in our favour.
It is crucial therefore that investment decisions are taken as a team. While one analyst leads on an idea, doing the bulk of the analytical work, all the other team members are also involved during this process, helping shape the questions that need to be answered. Each investment idea is owned by the team and each mistake owned by that same team. This creates a culture that ensures each mistake is not viewed as an opportunity to apportion blame, but for the team to do better, to look out for each other, and help everyone improve.
Acknowledging that we will get things wrong means our process is focused on the downside risks and we only like to invest when companies are priced for a poor future rather than the better times. This means that we understand the risks of it going wrong and should therefore position such investments accordingly. We only occasionally have become forced sellers – situations where things have gone so wrong that companies have had to cut their dividends. Typically, this has happened in one stock each year and they have not been more than 2% of the fund.
The sports analogy – what role do mistakes have in performance
Literature on sports gives three relevant insights into learning from mistakes. The first is that for most high-performance athletes, making mistakes is a key part of the process of getting better. In themselves, mistakes aren’t to be celebrated but they most emphatically are not the signs of failure. Instead they offer the key to improvement and show the path to the ultimate goal. The second is the process of honing and perfecting technique through repetition. Whether it’s a long putt, a cross court backhand, or a free kick set piece, the athletes will be putting into practice steps they have gone through countless times to ensure they can be repeated as near to perfection as possible. Only by a process of repetition can the lessons learned be internalised to become second nature no matter how the context differs. Finally, luck plays a major role in determining an outcome. There will be times when a process applied correctly can still yield a poor outcome and times when poorly executed processes can still deliver a good outcome. Recognising the role of luck is important when trying to recognise mistakes to learn from.
Investing can appear as if it offers few such opportunities for repetition and honing technique. Analysing a Japanese real estate company can feel totally different to investigating a European car company. Our approach has been to reduce this complexity by continually looking at the world through five buckets each with its repeating pattern of controversy.
A framework for understanding mistakes
Mistakes are complicated and messy. Hindsight can sometimes make it feel obvious what went wrong. However, in most cases an honest evaluation of what information was available at each stage makes it much harder to answer the question – what exactly should we have done differently? This is where we turn to our process and break down that very question into two very different parts: did we apply our process correctly, or did our process let us down in some way in this instance?
Our process relies on identifying an opportunity as falling within one of our five buckets of controversy. Each bucket comes with its own set of criteria and a checklist to complete. Most of our past mistakes that have involved not following the process were when we were trying to fit a stock into one bucket when it should have been in another. For example, a cyclical stock that should have been put into our profit transformation bucket but was put in ex-growth cash generators because its history had shown a benign period of extended good returns. The consequence of this mistake is to have asked the wrong questions, to have failed to model the downside analysis aggressively enough and to have had too large a position size. The key lesson is to learn that companies can flatter to deceive for quite some time if the backdrop allows; such as a period of cheap and abundant money. In other cases, we have found we have correctly identified the right bucket but not been strict enough in applying its criteria. Bucket 3 stocks, Capital Intensity, are those that havelower returns than the Capital Light buckets 1 and 2 companies – but, which share many of their quality characteristics in terms of stability of returns, defensiveness of their moats, and ability to compound growth steadily over time. In the past we have made mistakes here, because we have missed where the defensive moat was under threat. For example, a regulatory regime for a utility that had a long successful track record but was under significant political pressure because of bills going up.
Learning from mistakes should also incrementally evolve the process. Often, we’ve identified the key criteria but haven’t thought about all the different ways to test and demonstrate that criteria. In some cases, the main analysis of the process has been correct, but we’ve missed an important additional question that has a significant bearing on the risk reward balance. We’ve found that for special situations, a key aspect of the investment case is understanding how the timing of the resolution can influence returns. On rare occasions the wait for a successful outcome has eaten up much of the upside simply because of the time value of money. For profit transformation investments, we have correctly understood the cyclicality of the business, but missed how much the constraints on cash flow at the trough would force management into unpalatable decisions, cutting the dividends or selling off important parts of the company.
And a framework for putting lessons learned from mistakes into practice
Mistakes can be messy and so can the lessons to be learnt. Without the narrow focus that our process brings, an unstructured list of all the things one has learnt in the past can quickly become unmanageable. The five buckets of controversy and their repeating patterns bring a simple framework that can be easily tweaked to incorporate the lessons of past mistakes. The simplest way for us to do this is to amend the checklists that we keep for each bucket, which we refer to and check off whenever we invest in a new idea.
A stock example
Centrica – we initially invested on the thesis that the controversy surrounding competition in the UK market was not permanent and thus Centrica would ultimately prosper. The mistakes were:
1) the impact of deterioration in the rest of the business undermined cashflow and made the company less able to suffer the UK competition.
2) the timing of competitors going under was too optimistic – a low gas price allowed them to run for longer (now that they are all going bust in the UK is not a sign of getting it right, the timing was the mistake) and finally the political interference on bills in order to win votes. The lessons were to improve the checklist to flex the importance of deterioration of the rest of the business and to flex the timelines on key thesis assumptions further. We sold in 2019.
Lessons were learnt.
The information shown above is for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice.
No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.
Unless otherwise stated, all opinions within this document are those of the RWC Global Equity Income team as at 25th November 2021.