Conformity can be harmful to your wealth – 1st quarter, 2016
"Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”i ―John Maynard Keynes
I recently watched a documentary on the life of E.O. Wilson, titled Of Ants and Men.ii If you’re interested in either the natural world or human nature I highly recommend it. Wilson is an entomologist and biologist and the father of two significant scientific concepts, sociobiology and biodiversity. In the documentary, Wilson comes across as positive, engaging, curious and very much a gentleman. He seems like a good role model for growing old so I wanted to find out more about him.
I learned that Wilson was a polarizing figure accused of racism, misogyny and eugenics. Without going into too much detail, the controversy stemmed from his hypothesis that human behaviour is shaped by evolutionary forces, a combination of nature and nurture, rather than solely nurture or environmental factors. This hypothesis flew in the face of conventional thinking that we’re ostensibly born with a blank slate or tabula rasa and that our behaviour is shaped by experiences. For these views he was attacked both physically and mentally by his peers at Harvard, where he was a professor, along with both atheists and religious groups. Wilson was pretty good at upsetting everyone but he stood by his beliefs, which were based on his scientific observation of the natural world.
While Wilson had no political agenda, he argued that as scientists he and his peers had a duty to uncover the truth regardless of political correctness. I think it’s fair to say that Wilson must have felt very alone in his beliefs and I can imagine it would have been cold comfort that he found himself on a long list of great scientists who’d been attacked and persecuted for their beliefs, like Galileo Galilei. While it took time for the air to clear, Wilson’s theories ultimately led to him being honoured with scientific prizes, including the National Medal of Science in the U.S. and the prestigious Crafoord Prize from the Royal Swedish Academy of Sciences, as well as two Pulitzers. Everything I read about him confirmed that he’s the man I saw in the movie: kind, decent, thoughtful and a true gentleman.
By now, I’m sure some of you are asking what the heck does this have to do with investing? The answer is, a lot. The stock market is the product of thousands of people making independent decisions every day. These decisions are based on their beliefs, in this case on the value of a business. There’s incentive for being right and punishment for being wrong. On any given day as an investor, it can feel like you can do no wrong while at other times it feels like you can do no right.
In the short term, the market can be an exceptionally hostile place and it requires courage in your convictions to achieve success. While the circumstances and beliefs around investing are completely different from Wilson’s, the outcomes are similar.
Market circumstances are often driven by short-term reactions to economic or business activity, while disputes over beliefs are always about the true value of a business based on those circumstances. This drives stocks up or down short term. Ben Graham, the father of security analysis, said it best: “In the short run, the stock market is a voting machine but in the long run it is a weighing machine.”iii What he meant was in the short term stock prices can diverge from their true value as businesses but over the long term price and value tend to meet. This short-term disconnect between price and value is often caused by one of the most powerful forces in human nature, the urge to conform, and it’s ever-present in the market. Sometimes this herding behaviour is manic, leading to high prices like during the tech bubble of the late 1990s, while other times the herd is extremely depressed leading to market crashes like in 1987. To truly achieve success as an investor you must be able to recognize manic periods as an opportunity to sell and depressed periods as an opportunity to buy.
A central tenet of Cymbria's investment philosophy is our willingness to stand apart from the crowd. This doesn’t mean we try to be different for the sake of it. It means that we’ll avoid conforming with the popular view of the value of a business if we believe it’s wrong. While we haven’t been physically attacked for our beliefs (we believe our investors haven’t had a reason to do so), frequently we’re called out to defend the idea behind one of our investments. More importantly, our psyches can be attacked day-to-day by price changes in businesses we invest in. To believe that it’s easy to feel good when the companies you invest in are down 10%, 20%, 40% or more, is to lack basic understanding of human nature. It’s mentally demanding, but only in the short term.
Gregory Berns, a professor of neuroscience at Emory University, more recently conducted an experiment that confirmed earlier findings by social psychologist Solomon Asch that only about 25% of humans have the ability to stand apart from the crowd.iv He did this by showing participants a wrong answer to a question at the same time they were trying to answer that question. More than 40% of the time participants would defer to the answer provided to them. On the other hand, only 14% answered the question wrong when no wrong answer was first introduced to them. Human beings are very willing to conform to the thinking of others even when they believe they may be wrong in doing so.
In a recent article called Animating Mr. Market: Adopting a Proper Psychological Attitude, financial strategist Michael Mauboussin quotes Berns:
“ 'We like to think that seeing is believing,' but, Berns said, the study’s findings show that seeing is believing what the group tells you to believe."v
Another element of the experiment worth mentioning is what happened in the brain of those who remained independent (25% of participants). They experienced increased activity in the amygdala, the part of the brain that calls for immediate action.
Fear is a powerful trigger for the amygdala, and it’s behind the fight-or-flight response, a psychological reaction prompting us to fight or flee a perceived attack or threat to survival. Those who stayed independent clearly have a very different way of managing the fear response than the majority of the population and they deserve admiration because of their ability to overcome such an inherent part of human nature.
Interestingly, when you look at the world of professional investment management you find the same tendency for conformity. As we see in the following chart, 50% of all managed money does nothing more than try to achieve the same results as an index like the S&P 500. While half of managed money is considered “active” note that only a little more than 20% is considered “highly active.” This is the group that we fall into and the group willing to manage investment portfolios that look different from the index. The percentage of investment managers in this category fits well with the results of the previously mentioned behavioural experiments in that only about 25% are non-conformists.
Source: A. Petajisto, “Active Share and Mutual Fund Performance”, Financial Analysts Journal v. 60, no. 4 (July/August 2013): 79-93.
Why does this matter to you as our investor? It’s important because it has been proven that truly active management as defined by two specific criteria can add value. Those two criteria are active share and tracking error.
Active share simply means the percentage of a portfolio that looks different from the benchmark index. Funds with a 60% to 90% active share have been shown to outperform by 1.6% over the long term while funds with at least a 90% active share have outperformed by 3.6% annually.vi Cymbria has an active share of 97% as at December 31, 2015.
Source: M. Cremers & A. Petajisto, “How Active is Your Fund Manager?” Yale School of Management, 2006.
Source: M. Cremers et al., “The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance,” Social Research Network, 2013.
The other important factor that isn’t talked about nearly as much as active share is tracking error. Tracking error measures the amount by which a fund deviates from the performance of its index. High tracking error will often appear when a fund is overweighted or has made a factor bet in a certain market sector like technology or healthcare. As the following chart shows, factor bets have been shown to contribute most to underperformance over time. As with so much in life, having too much of something is rarely a good thing.
U.S. all-equity mutual funds 1990-2009
Reflects annualized equal-weighted performance of U.S. all-equity mutual funds for four types of active management. Returns net of fees and transaction costs. Excludes index funds, sector funds and funds with less than $10 million in assets. Four-factor alpha as calculated by Carhart's four-factor alpha model (1997). Source: A. Petajisto, “Active Share and Mutual Fund Performance”, Working Paper, December 15, 2010.
We like to say Cymbria is diversified by business idea and we try not to have much, or any, overlap in these ideas. With no factor bets, we believe this helps create the circumstances for an appropriate tracking error and hope our approach will lead to superior long-term performance.
If the recent bout of downward market volatility has left you scared and running for the exits, you have lots of company. When stock prices are falling and investors are fleeing the market, the Asch and Burns studies would suggest about 75% of investors' peers will want to join them. Yet while the experience isn’t pleasant psychologically, it’s at this time, when the market is a voting machine that Cymbria will invest more in the businesses we believe have the greatest chance of achieving above-average market returns long term. That’s because we believe that over time, the market is a weighing machine and that a business’s value and its stock price will converge. We also believe that our ability to think independently is one of our key competitive advantages.
Our approach at work
Since the end of 2011, Alere Inc. has been one of the largest equity weights in Cymbria. Alere recently received a takeover offer from Abbott Laboratories supporting our long-term investment thesis in the company.
Alere is the global leader in point-of-care diagnostics. If your doctor has given you a strep test and got the results in 15 minutes, there’s a good chance it was an Alere test. It’s a very stable business so you wouldn’t think it would have a volatile stock price but it does.
As an investment, Alere is a great example of how we don’t follow the herd. Many times over the years of our ownership uncertainty about Alere’s short-term performance caused downward volatility in its share price. There were two FDA product recalls, several missed quarterly earnings estimates, a 50% share price drop, many daily 10% declines, an activist investor that accused the board of ignoring its fiduciary duty by not making shareholders aware of a bid for the company, and the resignation of the founder and CEO as well as most of his team. In quite a few cases the stock sold off due to these issues and we often not only purchased stock but also increased Alere’s weight in Cymbria as you can see in the following chart.
Source: Bloomberg LP. January 5, 2009 to February 2, 2016. In US$. Weights in Cymbria as at: (1) 16-09-09, (2) 30-09-11, (3) 31-12-12, (4) 10-06-13, (5) 01-07-14, (6) 09-01-15, (7) 15-10-2015, (8) 28-01-2016, (9) 01-02-2016.
50% price decrease: September 2, 2009 to October 3, 2011. Since the takeover, as Cymbria has sold down its position, the stock price has fluctuated.
Because of our long-term belief in Alere, uncertainty and downward volatility allowed us to substantially increase our stake in the company which ultimately increased the payoff to our investors.
Alere is a perfect example of the market being a short-term voting machine and a long-term weighing machine. Stock price and business value can diverge over shorter timeframes but long term the two tend to come together. Some three years ago you could have bought Alere for $18 per share; today a competitor thought it was worth $56 per share. I don’t know if being non-conformist is the product of nature or nurture but in the case of Alere, the result has been very positive for us and our investors.
iJohn Maynard Keynes, The General Theory of Employment, Interest and Money (London: Macmillan, 1936).
iiE.O. Wilson – Of Ants and Me. Directed by Shelley Schulze. Washington.: Shining Red Productions, Inc. for PBS, 2015.
iiiGraham, Benjamin and David L. Dodd, Security Analysis: Principles and Technique (McGraw-Hill Companies, 1962).
ivSolomon E. Asch, Studies of independence and conformity: A minority of one against a unanimous majority, Psychological Monographs: General and Applied, Col. 70(9), 1956, p. 1-70.
vMichael Mauboussin and Dan Callahan, Animating Mr. Market: Adopting a Proper Psychological Attitude, Credit Suisse, February 10, 2015.
viCremers, M. and A. Petajisto, “How Active Is Your Fund Manager?” Yale School of Management, 2006.