Nov 2005

TWO TOUGH MEETINGS

In recent weeks I've been put on the spot at two meetings by the need to take tough decisions or handle tough questions. I'm still trying to work out whether we decided or answered for the best.

The first came as I was offered a brief opportunity to sit on your side of the table. Usually, I am the cowed fund manager seeking to justify aberrant performance to a group of stony-faced, pitiless professional investors, such as you. But that day I was looking forward to meting out some withering questions myself, because I was sitting on the investment committee of an institution, reviewing half a dozen household-name fund management groups, all pitching for a piece of its portfolio. For example, I was going to ask - "All the investment managers presenting today describe themselves as pragmatic and flexible theme-driven investors, with a preference for undervalued companies, with strong business fundamentals. If you're all trying to pick the same things, how do we distinguish between you?" Perhaps I exaggerate the homogeneity a bit, but it's notable how much commonality (almost cliché) there is across our industry.

However, before the circus began, the Chairman of the committee turned to me and said - "Nick, you're the only practicing investment manager on the panel, what should we be looking for from these presentations?" And this is when the gravity of the task sunk in on me. Here we were, about to take a decision about the stewardship of a very large sum of capital, based on a handful of 20 minute presentations and a few questions and answers. I flannelled for more than a short while, then struck on a proposition that I still can't improve on. "What we're looking for is a combination of coherence and passion." I said. "Coherence, because if the presenters can't make us understand what it is they do, then we must suspect they do not really understand what it is they do themselves. Passion, because, while there is no guarantee any investment strategy will succeed, we at least want someone who truly believes in what they do. The best investors are passionate, although obsessiveness does not guarantee investment success."

These, then, were the qualities we listened out for. All the presentations were of high calibre and all the houses short-listed had credible track records. How would you decide? What I found instructive, not least for developing Lindsell Train's own business, were what issues, trivial or not, swung the panel's thinking. For instance, by far the smartest presenter - in terms of obvious IQ and the extraordinary stream of ideas and insights that flowed out of him and his team - failed to progress. They lost points for two reasons. First, they grossly overran their allotted time. I increasingly feel that this is unforgivable (I'm not talking about a minute or two over). Banging on for too long either demonstrates that you've not properly rehearsed or given due consideration to what your potential client requested, or it suggests that you're ill-disciplined. They also suffered because some lay members of the investment panel couldn't make head nor tail of the process. This seems a harsh reason to miss out on a piece of business and, of course, investment is not simple and should not be portrayed as such. In the end, though, you have got to carry your audience and potential clients with you. I always remember my tutor telling me before my university Finals - "Write your answers as if you were addressing an intelligent seventeen year-old, not a seventy year-old academic." In other words, write with clarity and structure. This is advice I've ignored ever since.

Another team dropped out of contention due to lack of conviction. When asked to discuss his biggest position, it took a moment for the manager to recall his biggest bet and the justification was tepid. The panel decided it would rather go with a tracker fund than pay three times the fee for this wishiwashiness. Another extolled the unique investment process that had generated their, admittedly, very competitive equity returns in one region, but was forced to concede that his institution's other equity teams, spread over the planet, all pursued radically different approaches. His justification - that local markets demand local approaches - couldn't make us forget that this was a house put together by a string of acquisitions over the past decade. And we decided we wanted to back a single house style, not a patchwork quilt.

The winners prevailed for a variety of reasons. One plus point was that when asked to account for their excellent performance, this house was the only one to put down some of the success to luck - as well as process, teamwork etc. The panel liked this candour - it appeared grown-up and realistic. We all know luck plays a big part in the numbers. Another winning trait was the fact the process emphasises income generation. Now that happens to play well with me and you, too, know how comforting it is for relatively inexperienced investors, like many trustees, to receive regular, meaningful and mounting dividend cheques. The consultant warned us, quite correctly, that there is a danger that "income" and "value" investment strategies may be about to run out of steam, after five years of outperformance. Certainly, for instance, the willingness of investors today to push the five FTSE mining stocks down to an average yield between them of 1.5%, half that of the market average, suggests that we could be in for a phase of success for "growth" and "momentum" strategies, akin to the 1996-2000 period. The panel digested this warning, but decided it didn't want to switch between advisers on each future shift in the market's psychology and preferred to go with an "evergreen" approach it felt comfortable with. Sometimes, I concluded to myself privately, it makes sense to give the customer what he wants, even if that isn't necessarily what he needs.

One more question I asked every time, I asked out of a deep sense of grievance. I'd been asked the selfsame question at a Lindsell Train presentation a week or two before and found it the devil to answer. "You are professional investors, so you clearly do not subscribe to the strong version of the efficient market hypothesis. In what ways do you believe the market is inefficient and how do you exploit such anomalies?" A tough one to deal with, especially cold. Here is our answer. One, I must admit, I've subsequently polished up in private.

The truth is the London equity market is clearly quite efficient. We can confirm this anecdotally by observing how ferociously quickly prices react to changes in news or sentiment. It is hard to believe that acquisition of publicly available information confers any lasting advantage to investors. Or we can confirm it by considering that only around one third of actively managed UK equity unit trusts have beaten the best All-Share tracker fund over the last five years. What we professional market participants are tasked to achieve is not trivial.

However, we do believe that there are a number of inefficiencies in the market, which are exploitable. At least, we attempt to exploit them and explain our performance record, such as it is, in reference to these effects that we're trying to capture.

First, we've always been impressed by this quotation from Charlie Ellis, founder of Cambridge Associates, in his book "Investment : How To Win The Losers Game".

"The optimal level of market risk for the very long term investor is moderately above the average. This level makes sense because many other investors are not free to take a very long term view."

This idea excites us. If the market was completely efficient, it is something of a mystery that it ever goes up. Surely, all conceivable upside should be built into today's prices? However, the market exhibits a marked propensity to go up in the long term, suggesting two things. First, investors consistently underestimate the wealth-creating capacity of Capital - in the long run the surprises (by definition undiscounted and unexploitable) have turned out to be on the upside. Next, as Ellis highlights, there is a discount for liquidity in the market. Investors permit shares to trade below the intrinsic value of the underlying assets, because they value the opportunity to touch cash. That discount does, we think, represent an "inefficiency" and for certain, albeit patient investors offers the possibility of earning additional reward.

Next, we are sure there is a significant money-making opportunity captured in this recent comment from the Bill Miller, of Legg Mason US Value fame.

"The market has some psychological limit that it just doesn't go above. You can take advantage of that in the right companies."

He is thinking here primarily about the valuations accorded to technology companies. But as much as anyone, Miller has demonstrated that cash generative, high growth companies across a variety of industries can be astonishingly undervalued, even when trading on valuations that appear "abnormal" to many. I like to cite a piece of research conducted by Credit Lyonnais' pharmaceutical team in 1997. They observed then that in 1976 Glaxo traded on a P/E 50.0% higher than the market average - doubtless perceived at the time as "expensive". In fact, CL calculated, Glaxo should have been trading on a Price Earnings Relative of 850, if investors in 1976 had been able correctly to estimate the company's future earnings growth. Of course, making that estimate was not an easy thing to do in 1976, nor is it in 2005. Just as assessing that Google was "cheap" at its flotation price of $85.0 in 2004, compared to $406 today was not easy - although Miller saw that it was. The point is, we think, that the parameters that circumscribe "cheap" and "dear" in investors' minds are much too narrow. Investors are "anchored" to the top and bottom ends of a valuation range in a way that is not economically rational and is, therefore, inefficient. It can be hugely rewarding to buy a value-creating, strategically-advantaged company on 20.0x earnings and hugely damaging to your wealth to buy a supposedly "cheap" stock, in a value-destroying company on 10.0x. Cadbury is not necessarily expensive on 16.0x earnings, even though this represents a premium to the sector and the market.

We also note these performance statistics. Over 20, 10, 5 and 1 years the total returns on the FT All-Share Index have been 870.0%, 129.0%, 2.3% and 19.7% respectively. Meanwhile, the return on the S&P UK Equity Income Unit Trust Sector (the average of all "income" funds extant over the same periods) was 999.0%, 149.0%, 23.9% and 19.8%. So, equity strategies that focus on the generation of above average levels of dividend income have outperformed the market, over short and long term. We do not know why, but investors appear to suffer some systemic inability to price dividends correctly. By the way, the performance of the S&P UK Equity Sector, including all funds, of whatever colour, over those periods, was as follows, 642.0%, 109.0%, -1.99% and 15.7%. There have obviously been some value-destroying strategies at work in this sample and I want to bet that "growth" and "momentum" styles had something to do with the long term underperformance.

Final inefficiency. Participants should remember that there is a "social" function to capital markets, over and above their use in providing a place where assets get priced, more or less correctly. The "social" purpose of the markets is to get things built, to get change effected. Somebody had to finance the railways, the automotive industry, the airlines, the dotcoms. Somebody has to finance the discovery of increasingly scarce energy resources. One should just never fall into the trap of believing that because, say, railways were a social boon, that we or any other investor is necessarily going to make an economic return on the capital committed to these schemes. I remember thinking in 1999 that the dotcom new issue frenzy was insanity, that no one could ever profit from owning the speculative rubbish being foisted on investors (except for the brokerage community, of course). But, insane or not, it had to happen. And many investors, temporarily deluded, wanted it to happen. Indeed, the world is a better place for the capital that flowed into technology and telecommunications during the bubble, despite the appalling loss of value that resulted. Google emerged, the cost of communications continues to plummet. But the market was not efficient during that episode, because its valuation job got superseded, briefly, by its financing job. In 1999 Morgan Stanley surveyed the history of the 1243 technology IPO's that had been brought to market between 1980 and end 1998. Of the universe, 718 had made money and 525 had lost money, of which 96 had gone bust. The 1243 companies accounted for $1.9 trillion of market value by April 1999, but of that sum, the top 50 companies, or just 4.0%, accounted for $1.6 trillion, or 84.0% of the total. You needed Microsoft and you needed luck to really make investment profits from that myriad of new issues. But those new issues did the US economy a lot of good. Investors who keep a cool head during these speculative episodes can gain an advantage.

Nick Train
Dec 2005