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What game is your fund manager playing?

An excellent article by Shane Parrish on Farnam Street highlights the necessity of choosing to play the long game in order to achieve success in any given pursuit. Investing is no different.

As Shane points out, when it comes to life (and investing) we tend to overestimate the importance of luck on success and underestimate the role of making the small, every day choices that will eventually lead to success. Too often, we convince ourselves that another person’s success was just luck. We comfort ourselves with the idea that highly-successful investors like Peter Lynch and Howard Marks are merely the statistical outliers found in every game of chance. The reality is they aren’t. They are playing a different game to the rest of us. They play the long game.

Success is simply a matter of luck. Ask any failure. - Earl Wilson

The long game is harder than it sounds

With investing, the long game is hard to play, and frankly, it can be dull. It usually involves meticulous research, countless meetings, fact checking, number crunching, statistical analysis and rigorous peer review. But the results can be exceptional. The long game changes how you think about and conduct your investments.

Doing what everyone else is doing pretty much ensures that returns will be average. Doing something different or contrarian takes thought, discipline and a process that gets the details right and minimises mistakes. Doing the small things well everyday eventually compounds into something bigger.

By contrast, the short game involves forgoing the difficult or mundane jobs for activities which feel productive but are often not conducive to better investment decisions. The share market in particular bewitches investors with the promise of riches every day, but it is a conduit for transferring wealth from the lazy to the well informed. Watching stock prices rise and fall on screens, reading the on-line financial press, chatting to stockbrokers, checking emails and trading a portfolio for no other reason than ‘it feels right’ all look like useful activities. They aren’t.

Many activities are simply distractions

These activities are in fact distracting from what investors really need to be doing. Falling into this trap is easy, even for professionals. The short game offers promises of easy gains through ‘foolproof’ trading systems, hot tips from friends and stockbrokers or just because gut feel says a stock is going up or down. It is the difference between investing and speculating. For example:

  • Why study a company’s remuneration report when I can get my favourite stockbroker’s view on it over lunch?
  • Why try to understand financial statements when the latest research shows changes in consensus earnings forecasts are key drivers of stock returns?
  • Why bother with fundamental analysis when I can add value trading the portfolio all day using price momentum and my gut feel?
  • Why write-up questions before a company meeting when I can ring an analyst and ask their opinion?
  • Why think about where a company will be in five years when it’s the next quarter’s earnings that count?
  • And so on …

In the absence of a big chunk of good luck, the negative effects of the short game multiply the longer it is played. On any given day, the impact is small, but as days turn into months and years the results usually compound into disastrous performance. Fund managers who play the short game don’t realise the costs until they become too large to ignore. By then, it is too late.

Playing the long game may mean some suffering today with no guarantee that it will add value. Finding good ideas takes time and patience. Stock pickers have to kiss a lot of frogs before they find their prince or princess. Most people don’t like to suffer and when they see the ultimate success of others, they do not realise the many arduous steps it took to achieve that success.

I fear not the man who has practiced 10,000 kicks once, but I fear the man who has practiced one kick 10,000 times - Bruce Lee

Sorting out the long term from the short term

Many investment managers will say they play the long game, but how do you really know which game a manager is playing?

Short-term performance (5 years or less) isn’t always a clue because managers can get lucky with their stock selection or ride a wave of a temporary positive thematic. Strong, above average performance over 7-10 years is good and over 20 years is great. It’s much harder to fluke long-term returns.

Stock turnover is another good indicator. Fund managers who are playing the long game rarely have high stock turnover above 60% or more because good ideas are so hard to find and detailed research takes time. Knowing exactly why you own a stock is the key to weathering and profiting from share price volatility. Not having an investment thesis leads to wild and erratic share trading that destroys returns.

Another clue is a clearly articulated investment philosophy and process for beating the market. Do the manager's actions and stock holdings reconcile with their articulations? A good stock picker should not hold a portfolio of 300 names, for instance. Few individuals can know more than 15-20 stocks really well.

Manager incentives can be a good guide. Manager incentives can be heavily weighted towards short-term performance which can lead to behaviour that is in the interest of the fund manager but not in the best interest of the client. An incentive scheme that is weighted towards long-term performance better aligns the interests of both parties.

Firm ownership can also be important. Playing the long game can lead to periods of underperformance. Having an ownership structure that is supportive during periods of underperformance ensures the interests of clients are best served in the long run.

Playing the long game doesn’t guarantee success but it is a key to achieving success. While some people win through sheer dumb luck, they are the tiny minority. Picking a manager who is playing the long game is the best way to maximise the chance of achieving compound investment returns that are materially better than average.

 

Charles Dalziell is an Investment Specialist at Orbis Investments, a sponsor of Firstlinks. This report constitutes general advice only and not personal financial or investment advice. It does not take into account the specific investment objectives, financial situation or individual needs of any particular person.

For more articles and papers from Orbis, please click here.

 

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