TowersWatsonAsset ManagerReview

EQUITIES, or shares in local and global companies, have been the cornerstone of the multiasset-class investment portfolios that we cover in the Asset Manager Review.

The price at which a share trades reflects the market’s expectation for that company based on the collective views of buyers and sellers in the market.

Share prices are understood to be forward looking, as these expectations involve an element of judgement and forecasting by the market participants of the financial performance that the company is expected to deliver in future.

Benjamin Graham described the stock market as a “voting machine” in the short run, where share prices are influenced by the emotions of the market participants, similar to a popularity contest, but he believed that in the long run the market is a “weighing machine”, where share prices reflect the underlying or intrinsic value of a business based on its fundamentals (for example, the profits that it earns).

Equity market performance is typically reported by the returns on an index, like the JSE’s All Share Index, weighted by the market capitalisation (or market cap) of the shares comprising the index.

The index return aggregates the results of the activities of buyers and sellers of shares in the market.

In other words, the market return represents the average return across the market participants, where the gains made by investors who have done better than average (“winners”) offset the losses made by investors who have done worse than average (“losers”).

One can easily achieve an equity market return by simply investing in portfolio structured to track a broad equity market index – this will give you an average return.

Following a so-called “passive” strategy at the lowest possible cost should give you an acceptable outcome which, as Graham says in our opening quotation, is easy to achieve.

Of course, the not-so-easy part is deciding which index to track!

It is worth noting that the draft Regulation 37 to be made under the Pension Funds Act, 1956, recently issued by the National Treasury for comment, will require trustees of defined contribution retirement funds to consider the use of passive or enhanced passive investment strategies for their default investment portfolios.

This is consistent with National Treasury’s focus on improving the cost-effectiveness of retirement funds for their members.

The underlying premise of active management is that skilful active managers can earn above average returns by identifying and profiting from mispriced shares.

Mispricing arises when the expectations factored in to the share price for the company – the market’s consensus - are either too optimistic or too pessimistic, resulting in the shares being overpriced or underpriced relative to the underlying value (whatever that might be!) of the actual business.

If the investment manager who believes the share is mispriced is proven to be correct in his or her assessment, then, over time, the market will change its view of the company and reflect this by re-rating the share (either up or down).

This allows managers to earn above average returns, or “alpha” – if, over time, they are right more often than they are wrong!

Investment management and brokerage firms globally employ many smart, hard-working investment professionals whose primary function is to research companies and decide which shares are overpriced and which shares are cheap.

Overwhelmingly, it is these investment professionals whose decisions represent the market consensus which determines the prices of shares.

On average, therefore, these investment professionals must be right half the time and wrong half the time – as a group, they can’t beat the market, because they are the market.

To achieve better than market returns, a manager must possess a unique insight or competitive advantage over his or her (almost equally smart) competitors – this competitive advantage or “edge” is often described as the skill of the manager. It is not enough for a manager to just have an “edge” – one also needs to assess whether this “edge” is sustainable, so that there is a good chance that the manager can deliver above average returns in future.

The hunt for “alpha”, or risk-adjusted better-than-average returns, is one of the main objectives of active management, but in recent periods it has been difficult for active managers to beat market cap indices.

Over the last ten years to 30 September 2015, five out of twelve managers in the Single Manager Industry Median category beat the Towers Watson Global Balanced Benchmark, before deducting manager fees. (The benchmark is a blend of market-cap weighted equity and fixed-income indices.)

The picture looks significantly worse over the last 12 months to 30 September 2015, in which only two out of fourteen managers beat the Towers Watson Global Balanced Benchmark, before fees.

Clearly, achieving superior performance is not straightforward. What competitive edge should managers possess to earn above average returns?

Michael Mauboussin splits manager skill into three parts in his paper, Untangling Skill and Luck, published in 2000.

The first part of skill is an analytical edge, where a manager is able to distinguish between the range of likely outcomes for a company based on the underlying fundamentals of that company (how the company generates revenue and incurs costs to earn profits), and the expectations that have been priced in by the market.

Mauboussin uses the analogy of horses at the racetrack – to make money at the racetrack, you need to figure out whether the odds quoted on a horse correctly reflect the likely performance of the horse.

As he says, “There are no ‘good’ or ‘bad’ horses, just correctly or incorrectly priced ones.”

The second part of skill is a psychological or behavioural edge, where a manager is able to bet against the herd.

To earn the market return, you simply follow the herd, and therefore to beat the market, you need to go against the herd.

This requires a manager to take a contrarian position, which often lead managers to invest in out-offavour stocks or sectors – this can be an uncomfortable position for the manager (as well as for their clients!).

Over the last few years, some local managers have made investments in the Resources sector of the FTSE / JSE All Share Index, which has delivered very poor investment returns over extended periods compared to the Financials and Industrials sectors.

In our view, a manager should not take a contrarian position in an out-of-favour share or sector simply for the sake of going against the herd – the manager must be able to explain why the market is wrong, and what the “catalyst” might be for the perceived mispricing to be corrected.

The market may indeed be right in its assessment of that company or sector, and so the manager needs to guard against overconfidence in his or her ability to value companies better than the market, and against “confirmation bias” (the tendency to pay attention only to information that reinforces the manager’s view, and to reject information that challenges it).

The third part of skill relates to organizational constraints that investment management firms face, specifically whether the interests of the manager (the agent) are aligned to the interests of the client (the principal).

Investment management firms are in the business of managing money to deliver superior returns to their clients, but also aim to make a profit from performing their services.

The challenge that the client faces is whether the firm prioritises delivering superior returns for its clients, e.g. by limiting the growth of assets under management, or whether the firm prioritises making profits by growing their assets under management to earn more fees.

Howard Marks of Oaktree Capital provides another perspective on what is needed to earn superior returns.

When it comes to investing, Marks argues that there are two levels of thinking, namely firstlevel and second-level thinking.

He describes first-level thinking as being superficial and simple. A first-level thinker will say “this is a good company” and on that basis invest in that company.

If the market agrees that it is a good company, then this expectation will be reflected in the share price and therefore the manager will not be able to earn superior returns from this investment.

A good company can be a good investment if it is acquired at the right price – where the market has not fully recognised the potential of the company and the positive outlook is not yet reflected in the price.

As Warren Buffett points out in his 1999 letter to Berkshire Hathaway shareholders, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

What is necessary to achieve better than average returns, says Marks, is second-level thinking, which is deep and complex. A second-level thinker will also say “this is a good company”, but will look at what the market thinks and what is already reflected in the share price, and will compare this to what he or she thinks.

A second-level thinker will consider a range of possible future outcomes and the likely odds attached to those future outcomes (after all, the future is unknowable, so you need to allow for the possibility that the outcome you expect might not play out!), and what will happen if the market is proven to be right and the investor’s judgement is wrong.

Better than average performance does not in itself prove that a manager is skilful – indeed, an investor could have been lucky with some of the decisions that led to positive alpha.

Likewise, below average returns do not prove that a manager is not skilful – an investor could have been unlucky with his or her decisions owing to bad timing or the manager’s investment style being out of favour.

In the world of investing, luck certainly plays a role in the outcomes that are achieved, so it is important to understand the manager’s investment process to see whether above-average returns are likely to be achieved in future.

Warren Buffett gave a speech in 1984 titled The Superinvestors of Graham-and-Doddsville, in commemoration of the fiftieth anniver- sary of the ground-breaking book Security Analysis by Benjamin Graham and David Dodd.

Buffett addressed the question whether investors who beat the market are simply lucky (because share prices fully reflect all available information on a company, so that the market price is always correct) or whether they have skill.

He presented the results of a group of nine investors who beat the market over long time periods and were invested in different companies.

The common theme with this group was their intellectual framework for making investment decisions – what they shared was their “intellectual patriarch”, Ben Graham and their investment approach, which led them to search for “discrepancies between the value of a business and the price of small pieces of that business in the market.” Jainudin Cariem Towers Watson November 2015