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Our process must have a competitive advantage to consistently identify and take advantage of mispriced opportunities

Informational
advantage

Find public information the market does not fully understand or appreciate

Analytical
advantage

Weigh information differently as our attitude to market efficiency and risk is different

Organisational
advantage

Eliminate obstacles for better decision-making

Position size
advantage

Conviction positions are required to capture mispriced opportunities

Informational advantage

Informational advantage requires finding public information the market does not fully understand or appreciate. We believe most investors focus much of their time to gain an informational advantage and overall, they do a very good job in collecting considerable amounts of data. This is the underlying reason why the market is efficient most of the time.

However, we believe the informational advantage of any individual is limited because of:

  • the ease and speed with which information can be gathered online and through information services such as Reuters, Factset or Bloomberg, and
  • the collective efforts of thousands of intelligent, hard-working and highly motivated participants make the competition for information intense.

Given informational advantage is the hardest to consistently leverage, it often means that more time and effort through hard work or bigger investment teams are not pre-requisites to deliver investors sustainable outperformance.

At Vertium, we work hard and more importantly, we work efficiently, to gather vital information for our analysis. Occasionally we may have superior information, however we are aware the market is sufficiently efficient for this to occur only infrequently.

Analytical advantage

Even though we have access to the same information as the market, our analytical advantage comes from weighing information differently because our attitude to market efficiency and risk is different.

We approach investing with humility because we believe the collective wisdom of crowds is often correct. Hence, our research must deliver a higher burden of ‘proof’ to ensure our investment theses on mispriced securities are correct.

Further, because we aim to avoid losing our investors’ capital, we spend considerable time focusing on downside risk. Accordingly, our line of questioning, and hence our research direction, is first based on ‘how much can we lose?’ rather than ‘how much can we make?’.

Specifically, we stress test our investment thesis with the following questions:

  • Have we overlooked any hidden risk?
  • Given the known risks, what can go wrong?
  • Is the downside limited?
  • Are we happy to own more if the security is cheaper?

Our approach to downside risk is an evidence-based, margin-of-safety approach. We are not in the business of prediction and do not take on risk purely to be contrarian: we believe both are risky endeavours. The evidence must be clear to show a margin of safety before we invest any capital. We actively reject stocks with little margin of safety, such as superficially cheap value traps or expensive high-quality stocks.

Our margin-of-safety approach leads to our portfolio comprising lower-risk, higher-quality stocks with sound valuations.

At Vertium, we believe owning companies we consider to be high quality and attractively priced to be the most compelling way to generate sustainable, long-term risk-adjusted performance for our investors.

Organisational advantage

Foolish decisions can be made by highly educated people. We believe intelligence does not necessarily lead to rational decisions with Warren Buffet describing this best in a letter to Berkshire Hathaway shareholders in 1989:

“My most surprising discovery: the overwhelming importance in business of an unseen force that we might call ‘the institutional imperative’. In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence.”

Like Berkshire Hathaway, Vertium strive to promote an environment that supports rational thinking and minimises systematic decision errors stemming from emotions, ego or misguided incentives.

While most organisations just focus on the ‘what’ or the mechanics of the process we spend an equal amount of emphasis on ‘how’ the process is performed to avoid systematic decision errors.

Based on ‘how’ we operate (organisational design) we believe we have three competitive advantages:

1. Cultural advantage

We believe we provide the right environment to make decisions.

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2. Behavioural advantage

“The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham

“To invest successfully over a lifetime … [requires] a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.” – Warren Buffet

“A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control.” – Charlie Munger

Investing requires dealing with an uncertain future. Faced with uncertainty, individuals often make decisions by simplifying information. In doing so, they can inject cognitive bias into their decisions. While these invisible forces that influence our decision-making help us in our daily routines, they can have serious consequences when investing. When emotions, ego or misguided incentives are intertwined with cognitive processes, individuals may make irrational investment decisions while remaining unaware of their presence.

In the presence of cognitive biases, meta-decisions (deciding how to decide) are just as important as analytical processes because of their hidden influence. When cognitive biases take over, they can short-circuit the best analysis.

Hence, we believe successful investing requires a decision-making process that minimises behavioural biases since investment mistakes are often psychological rather than analytical. Our stock-selection process has a decision-making framework that explicitly accounts for behavioural biases, helping to improve the quality of our investment decisions.

Our stock-selection process sequentially flows in three stages: idea generation, analysis, and investment. We are acutely aware once an initial decision is biased (narrow-framing bias) in the idea generation stage the following choices tend to become largely an exercise in rationalising that initial decision (confirmation bias) in the analysis stage and potentially building optimism (overconfidence bias) in the investment stage.

To minimise cognitive bias and its impact on effective decision-making, our investment process has in-built counter-measures:

Cognitive Bias Counter Measure
Idea Narrow-framing Re-frame
Analysis Confirmation Reality test
Investment Overconfidence Pre-mortem

Of the three cognitive biases, the overconfidence bias is potentially the most damaging because it stems from cognitive dissonance mixed with ego. Our belief is that ego-centric individuals often strive to remain consistent with their ‘stubborn’ beliefs. Hence, when decisions conflict with their beliefs, these individuals justify their choice by looking for confirming evidence and ignoring contradictory signals, hence creating blind spots.

At Vertium, we believe systematic decision errors are avoidable. Successful investment outcomes are more likely to come from a culture that promotes rational thinking and minimises cognitive biases. Hence, ‘how’ we invest is key to successfully implementing ‘what’ we do in our investment process.

3. Process evolution advantage

We believe our investment process must improve from its mistakes. Hence, investment post-mortems are a critical part of our process.

All stocks in our portfolio undergo a post-mortem review. We analyse the outcomes to understand the result drivers:

  • Skill: right result for the right reason
  • Lucky: right result for the wrong reason
  • Unlucky: wrong result for the right reason

Understanding our mistakes (lucky and unlucky) allows us to investigate and improve that specific area in our investment process.

For stocks we exclude from our portfolio, we also undertake a post-mortem review of outliers: stocks that have performed extremely well, and stocks that have performed poorly. We aim to understand what led to their outcomes and importantly, whether our investment process should have captured the winners and more importantly whether our process is appropriately designed to avoid the losers.

At Vertium, we believe success is defined by how we learn from our challenges.

Position size advantage

Mispriced opportunities are not always abundant. When they appear, concentrated positions are often required to capture the full extent of the opportunity to deliver investors superior risk-adjusted performance1. We believe index-huggers, even with superior skill, cannot outperform considerably.

Funds management industry participants are highly incentivised to gather assets because they earn a management fee as a percentage of their funds under management (FUM). Even with superior skill, active managers in their early years often have larger concentrated positions, but as they accumulate FUM, their position sizing is likely to shrink until they almost hug the index2. To deliver investors sustainable, superior risk-adjusted performance from concentrated positions, we believe it is critical to keep FUM at a manageable level.

At Vertium, we maintain our position size advantage in two ways:

● Limit our stock positions to under 40 stocks to ensure our best ideas are not ‘diworsified’,
● Limit FUM capacity to ensure the sustainability of our performance.

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Notes

1Although most studies have come up short on linking active management with outperformance, a stronger link has been found with active managers that invest with high conviction. Researchers have found that fund managers with large active positions are more likely to outperform their benchmark (Cremers and Petajisto, 2009)

2Researchers have found that some fund managers are in fact skilful, but they will accumulate FUM until their alpha generation disappears (Berk and Binsbergen, 2015). For example, Peter Lynch managed the Fidelity Magellan Fund for 13 years. In the first five years managing the Fund, he had monthly gross alpha of 2% on average assets of about US$40 million. In his final five years, he delivered 0.2% monthly gross alpha on assets that ballooned to US$14 billion.

References

Cremers, M., and Petajisto, A., 2009, How Active Is Your Fund Manager? A New Measure that Predicts Performance, Review of Financial Studies, Volume 22,
Number 9, pp. 3329-3365G

Berk, J., and Binsbergen, J., 2015, Measuring Skill in the Mutual Fund Industry, Journal of Financial Economics, Volume 118, Issue 1, pp. 1-20