Volatility – friend or foe?

Volatility will always be a fact of life as investors in the equity markets, but to us, rather than representing risk, volatility represents opportunity.

We have established a path to success that has been consistently framed by investing in structurally advancing economic ecosystems along with companies that possess sustainable advantages. Those advantages allow the right companies to compound a high return structure for many years. Combine that with an appropriate price tag, which short-term volatility can often provide, and you have the gist of what we do.

Are markets efficient?

The 1950s and 1960s brought forth an academic school of thought that markets were efficient, too efficient to even attempt to outperform. There are, however, a sizable list of active investors who have debunked the notion that it is impossible, us included.

Hard it is, but it isn’t impossible. Doing so requires a mindset that is perhaps not widely held in the asset management business. As Warren Buffett once commented, the way to beat Bobby Fisher was to play him in any game but chess.

Active investment requires first and foremost that you are content to be willing to be different, and that’s harder to do than you think. The philosopher Eric Hoffer once noted that if you give people absolute freedom to do as they wish, they’ll imitate one another. That’s nearly as true in investing as it is with fashion or hair styles.

Finding the winners and losers

There is much social pressure to hold uncontroversial views. Business media and the sell side are big contributors to this. They always want you to do something based on the day’s or hour’s newsflow. Just watch analysts raise their price targets only as the price of a stock goes up and lower their price targets only as the stock goes down, never straying too far from the actual price in the market.

It takes a unique personal composition to feel completely comfortable waking up every day believing the rest of the world is wrong about something. We actively seek this trait in people, and we are skeptical it can be taught. It is required for success.

We believe it is possible to outperform the market, as noted above, because we have done it, along with a number of our immediate colleagues. For sure, the dispersion of sizable active winners is not wide – the truth is that active management is similarly subject to the same power laws that one sees play out in sports and in most of the performing arts.

The Premier League, for example, has 548 players. According to FIFA there are nearly 250 million people in the world who play, referee or otherwise officiate football games. That is a power law at work, the rewards which are large, go to the few. Los Angeles is legendary as a city full of waiters, bartenders, and carpenters who are also “actors” or “producers”. Scarlett Johansson, George Clooney, and Steven Spielberg are the exception, not the rule.

The benefits of active

The main reason to invest with an active manager is a very simple direct one, they can make you money, and with the best ones, an awful lot more of it than a passive index can. The rewards go to the few. Unlike sports or the arts, you can participate too. You just have to figure out who the few are. That’s easy – they leave a track record that makes it obvious for you.

Outperforming requires that you be doing something different, do it well, and behave consistently over time. Compound performance doesn’t accrue in a straight line. It requires that we research deeply and think very big about the broad direction of how we’ll live, work, and communicate with each other a number of years into the future, and hold companies that are both shaping the future and benefitting from it.

Are passives always cheaper?

The knock-on active investing versus passive is usually that the costs don’t justify it. Often, however, we find that it is overlooked that passive vehicles have expenses too. In fact, the ETF which is commonly used to track global equities carries an expense drag of 31 basis points a year. If one adds an additional layer of advisory expenses on top of that, you are locking in a performance path in the future that will trail the index by the compounded drag of that expense burden.

In doing so you won’t be matching the index, you’ll trail it by quite a bit over long holding periods, which is one of the things passive adherents often cite as a reason to not own active. The “index” and investing in the index are not the same thing. Let us not forget that.

The importance of capital allocation

It also can’t be overlooked that public markets were established to allocate capital and provide liquidity to investors. In our opinion, Index investing is a potentially problematic way for investors, or society as a whole, to allocate capital, yet we are doing so at an ever-increasing scale.

By definition, it places its largest allocations towards the winners of the past, with no discernment when buying or selling as to the economic logic of doing so. Over the span of our careers we have seen many things that became accepted wisdom that didn’t quite work out as planned, and that nearly always grew out of a comfortable consensus.

There seems such a consensus brewing around passive of late. The age-old problem with risk is that it doesn’t wear a name tag and stroll up to introduce itself. It lies in wait. Now, more than ever, you want an active manager on your side finding the right opportunities.