Recently, Bill Miller, a highly regarded portfolio manager with Legg Mason in Baltimore, announced that he was stepping down from his day to day fund management responsibilities. Among the many reasons Bill is held in high regard by our profession is his record of outperforming the S&P 500 for 15 consecutive years from 1991 to 2005. For me personally, I always enjoy listening to anything Bill has to say and reading anything he writes because he demonstrates both immense intellectual capacity and an insatiable curiosity about how the world works. Interestingly enough, Bill was a philosophy major in university which is not the usual educational route to Wall Street.
A couple of years ago, I was particularly struck by comments Bill made in an interview with Morningstar. He was discussing the three different types of edges a money manager can have over other portfolio managers and investors. He labelled these advantages an analytical edge, an informational edge and a behavioural edge. Let me describe and build on what Bill discussed with Morningstar and outline how these apply in our investment efforts on your behalf at Stacey Muirhead.
An analytical edge refers to the ability of an investor to interpret or massage all of the quantitative and qualitative data available to arrive at superior investment decisions. An informational edge refers to the ability to develop proprietary or unique information that can lead to insights that are not available to others that result in better investment decisions. A behavioural edge refers to the ability to understand and control certain hard wired behavioural tendencies of people that can lead to poor investment decisions.
Does Stacey Muirhead have any of these edges? Do they give us a sustainable competitive advantage of other portfolio managers and investors? Let me start by stating that the investment management profession is intensely competitive and getting any edge at all is hard to achieve. While we do not consider ourselves stupid at Stacey Muirhead, I have to be honest and tell you that we do not possess an analytical edge over the many brainiacs that populate our profession. There are many smart people and computer geeks in the investment management business that demonstrate immense analytical ability. We will certainly keep trying but this is not likely to ever be the type of edge that we can develop or sustain over the long term.
Developing an informational edge is more likely. Let me be clear about what I am not talking about when I am discussing an informational edge. From time to time, some money managers are able to obtain an informational edge by engaging in illegal activity that results in insider trading profits. This type of informational edge is usually temporary and almost always ends up in criminal prosecution. I can assure you that I have zero interest in downsizing from my current living space to a 10 by 12 foot cell or to interact with my wife by phone through a Plexiglas window! To the credit of regulators, the adoption of Regulation FD (FD stands for “full disclosure”) which requires companies to disclose information to all investors at the same time has done much to curb abuses. We think that we have been able to develop at least a modest informational edge for our investors over the years by working harder to develop information that leads to a better understanding of the sustainable competitive advantage that our companies possess. Our investment success with Nu-Gro Corp. many years ago was at least in part the result of visiting over 60 Canadian Tire stores (Nu-Gro’s largest customer) to see firsthand how effective Canadian Tire was in merchandising and selling Nu-Gro’s products and how engaged consumers were with the Nu-Gro product line. Today, I would like to believe that our extensive travel schedule gives us an informational edge over others as we are able to observe first hand in many countries around the world what consumers are eating, drinking, wearing or using in their day to day lives. Most global investment managers rarely leave the office believing that all the information they need to reach good investment decisions can be found in their investment databases and Excel spreadsheets. We intend to continue to build on our current informational edge over time and look for ways to develop a further informational edge.
Without question, the biggest edge we possess at Stacey Muirhead is our ability to recognize the behavioural traits that lead to poor investment decisions. The list of behavioural mistakes that investors make over and over again is long but let me provide one example. Investors tend to extrapolate recency in their decision making process. By this, I mean that when a company has performed well in the immediate past, investors tend to become overconfident about the continuing prospects for a company and overemphasize the positives. Similarly, when a company has reported bad news or has posted poor performance results in the immediate past, investors often overreact and believe that the negatives will persist forever. Investors who recognize this common behavioural trait can gain an edge and exploit such a situation for investment gains. Even Benjamin Graham recognized the importance of exploiting the negative behavioural tendencies of others. In the first edition of Security Analysis which was published in 1934, Ben quoted Horace from Ars Poetica on the very first page of his book. He wrote “Many shall be restored that are now fallen and many shall fall that now are in honor”. While we are not perfect and I am sure that we get trapped behaviourally on occasion, we do expend considerable effort to learn about and recognize the behavioural mistakes that people make that lead to poor investment decisions. We think that we do have a behavioural edge at Stacey Muirhead. This edge has been and will continue to be an important contributor to our investment results.
“Above the Fray” is a regular blog written by Jeffrey Stacey, Chairman and CEO of Stacey Muirhead Capital Management Ltd., which discusses items of interest related to investing, finance and business. This is not a solicitation.