This is a tale of four fund managers at Global Megabucks Asset Management: Danny Defensive, Ivor Income, Vinny Value, and Sue Sensible.
Danny Defensive was an extremely confident fund manager who drove a Porsche and would never stop to ask for directions even when he was hopelessly lost. He was also very convinced about his own ability to forecast macro-economic trends and seemed to be permanently gloomy about the state of the economy. Danny therefore structured his portfolio to cope with the depression that he always thought was on the horizon by owning large defensive equities, as well as holding cash, bonds, and gold. As the economy swung into a downturn, Danny would do very well, and his marketing team would send him out on a victory tour of the UK in which he would speak to large audiences on the subject of ‘how he had seen it coming’. This usually meant lots of money would pour into his fund when his favourite defensive stocks were very popular (and very expensive) and just before the cycle picked up and they did very badly. The salesforce would then spend the next couple of years advising the new clients to just hang on for the next economic downturn when the fund was bound to start doing well again.
Ivor Income had read many studies which showed that stocks with high dividend yields do better than the market over time. These studies seemed to just rank all the stocks in the market by dividend yield and showed how the highest yielding part produced superior returns in the long run. ‘This is great’ thought Ivor. ‘I will spend a couple of hours at the start of January sorting the market by dividend yield, buy the highest yielders for my fund and spend the rest of the year on the golf course’. For a while this worked well as Ivor’s fund did well on average (although not every year) and Ivor got his golf handicap down to 4. But in 2008 something strange happened. Ivor ran his screen at the start of the year as usual and noticed that the banks, housebuilders, airlines, retailers, insurers all had thumping great big yields and low price-to-earnings ratios to boot. ‘This is going to be a great year’, thought Ivor and his sales team started a marketing campaign showing how high Ivor’s fund yield was. When Ivor returned next year, he could scarcely believe his eyes. Many of his companies had cut their dividends, some had rescue rights issues and some no longer existed at all. Ivor’s sales team were not happy when they had to tell clients who had bought the promise of the high yield that they were cutting the dividend on Ivor’s fund.
Vinny Value had read lots of books about Warren Buffett, John Templeton and Ben Graham and had convinced himself that contrarian deep value was the way to go. For many years this had worked well as he waited for the economy to turn down and then stepped in to buy all the lowly valued cyclicals that Harry Hedge Fund was selling. So far, the central banks had always stepped in by slashing interest rates and sometimes printing money which meant the share prices of the beaten down cyclicals had soared, and Vinny’s fund did well. As markets plummeted in 2008, Vinny saw another great opportunity as some financials traded at less than half their tangible book value and Vinny stepped in to take advantage of other people’s fear. He loaded up on names like AIG, Fannie Mae, Freddie Mac, and Lehmans in the US whilst also buying HBOS and Royal Bank of Scotland in the UK and sat back to wait for the recovery. In 2008, Vinny’s fund was down 55% wiping out his 10 year track record. In 2009, he lost half his assets to redemptions and in December 2009, he was called in to a very brief meeting with his HR manager and his boss.
Sue Sensible was less confident about her ability to forecast things than her male colleagues. The sales team didn’t like this as when she was asked to give her view on the economy or the market, she would often say she “didn’t know”, whereas Danny, Ivor and Vinny always had an opinion. Like Vinny, Sue also had an eye for a bargain but unlike him, she always bought well.
Vinny had once come back to the office with ten pairs of boxer shorts he bought from the market place for £5 but which only lasted him a month. Sue, on the other hand, had once saved up for a business suit from Chanel but she had waited to buy it until it was half price in the sales. Sue’s strategy to selecting stocks for her fund was similar; like Danny she looked for high quality defensive stocks but she only bought them when they were cheap. Like Ivor, she was attracted to beaten down stocks but she would avoid poor quality businesses or those with excessive financial leverage. Like Ivor, Sue liked shares with high dividend yield but she tended to avoid the ones with the highest yields which experience had taught her were high for a reason.
The sales force never spent much time pushing Sue’s fund as, whilst it was better than average most years, it was never in the top decile which was what they needed to shift product to meet their sales targets. Then, one morning, Simon Snakeoil, Head of Distribution at Global Megabucks said in the weekly sales meeting ‘My God, you’re not going to believe this, Sue is top decile over the last five years! Get her out on the road NOW!’
——————————————————————
We hope the story above provided a bit of light relief in your day, but we also wanted to make some serious points.
First, Income and Value are frequently regarded as being one and the same, but this is not always the case. Assuming a high dividend yield stock is good value can backfire – particularly when dividends are being paid out of unsustainable earnings (i.e. banks in 2008) or when they are paid using borrowed money (i.e. utility companies now).
Second, there is a perception that Value is defensive in a stock market decline, but again the reality is not as straightforward. Whilst ‘Value indices’ are often dominated by sectors such as autos, airlines, steel, and financials, real value rotates around the market often as a function of the economic cycle. In the early stages of a downturn, investors usually sell cyclicals and buy defensives meaning that the former group ends up representing good value whilst the latter becomes expensive. We saw this happen in 2020 as the world entered a recession brought on by the response to the pandemic. At the first sign that we were exiting the lockdown, market leadership switched to low valued cyclicals.
Third, no investment approach works all the time. Short term performance and being temporarily in vogue tells you very little about a fund manager’s skill in the long term.
I would recommend reading ‘Death, Taxes and Short‐term Underperformance’ by Brandes Research Institute, and ‘Are Short‐Term Performance and Value Investing Mutually Exclusive?’ by Eugene Shahan.
The key message in these theoretical studies is that the most successful investors tend to act differently from the market, and as they cannot control when the market comes round to their way of thinking, their performance will naturally diverge from that of the market, sometimes positively but sometimes negatively. Consecutive, positive, annual relative returns are generally not the hallmark of a great investor and nor should they be.
Fourth, the worst thing to do is take these random patterns and read something into them i.e. to buy Danny after his defensives have done well, or to sell Vinny because his value stocks have fared badly.
We recently read a lament from Peter Lynch, the former manager of the Fidelity Magellan strategy, that half of the investors in his strategy had lost money, despite it averaging an impressive 29% annualised return under his management. Why? Because they had bought it after it had done well and sold it after it lagged. (source: Forbes)
In our opinion, the key to selecting a good fund manager involves the following questions:
– Do you understand their philosophy? Are you buying Dave, Ivor, Vinny or Sue?
– Is there evidence that this philosophy can produce excess returns in the long run? Buying low valued stocks can be shown to produce excess returns; the same cannot be said for ‘we are good at identifying themes’ or ‘we have 200 analysts who attend 5000 meetings a year’.
– Can they demonstrate that they have successfully applied this strategy over a long period of time?
-How can you ensure that they are in the right operating environment? Do they have the mental fortitude to stick with it when it is not working? Does their boss? Do you?
-Lastly, if you are confident in their long-term ability, are you willing to invest when their style is out of fashion, when short term numbers are poor, and to be patient for at least five years?
Key Information
No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. Past performance is not a guide to future results. The prices of investments and income from them may fall as well as rise and an investor’s investment is subject to potential loss, in whole or in part. Forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so. The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of Redwheel. This article does not constitute investment advice and the information shown is for illustrative purposes only.
