4 Sources of Edge for Active Managers

By Simon Hallett, Vice Chairman | May 21, 2021

People are deeply flawed when it comes to making investment decisions. It is vital for active investment managers to be aware of their own behavioral defects as humans and counter these shortcomings with process. Good active managers must be able to identify their “sources of edge,” the characteristics that enable them to generate sustainable alpha.

The sources of edge are often described as Informational, Analytic, Decision-making, and Organizational:

Informational

In an era of Artificial Intelligence and Big Data analysis, it’s very hard to generate an informational edge through data acquisition alone. Those who do find anomalies see them quickly arbitraged away. There is, though, the possibility of generating an edge by extending your time frame. A large segment of the market today is concerned with generating products based on dataset analysis, which generates excess returns for short periods of time, in the full knowledge that that advantage is temporary. However, no one has been able to turn the identification of companies that can generate returns over long periods of time into an algorithm. Focusing on long-term industry competitive dynamics and individual companies’ own competitive advantages within their industries can lead to insights that short-term data analysis often misses.

Analytic

Separating signal from noise can provide a potent analytical edge. As Benjamin Graham wrote in The Intelligent Investor:

“People don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.” Having a series of rules that help determine the passage of a company from the wider universe to research coverage is extremely helpful. Being structured in how to conduct research and pre-committing to the characteristics sought in a company are essential. Be objective in embracing what works from quantitative processes and systematic fundamental analysis. Structure and discipline help overcome human biases. Admit and learn from mistakes to be more objective and establish a framework to help analysts communicate with colleagues. The structure and discipline will help them focus on what’s important, and filter out what is not.

“Focusing on long-term industry competitive dynamics and individual companies’ own competitive advantages within their industries can lead to insights that short-term data analysis often misses.”

Decision-Making

Understand that all human beings have biases that inhibit both thorough analysis and sound decision-making. A good manager needs to set up structures to overcome these biases, and make sure that all team members stick to those structures. Overcoming our emotions and learning how to avoid cognitive errors should be at the core of any process that results in making decisions, especially decisions made under conditions of great uncertainty, which clearly includes investment decision-making. Conviction and confidence help sell ideas but may not be accurate guides to the success of those ideas.

Organizational

Incentivize analysts to get their decisions right, not to persuade portfolio managers. How an organization is structured, and how its people are incentivized and compensated, can provide the background that facilitates good decision-making and is thus a source of “organizational alpha.” For example, incentives should in part focus on long-term performance so that they’re aligned with the long-term nature of the informational and analytical edge. Moreover, individuals need to be accountable for their decisions to avoid the blame game that arises from consensus or group decisions. Finally, a good investment manager needs to communicate with clients, and, above all, set their expectations accurately.

At Harding Loevner, we think we have an edge because of what we know about decision-making and the structure and discipline of the process. Our analysts provide the necessary ingredients for successful, systematic portfolio construction. Our decision-making structure imposes individual accountability, mitigates biases, and ensures continuity, leading to better decisions and aligning each of us with our clients’ objectives.

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Out of Our Minds—From the Beginning

By Simon Hallett, Vice Chairman | December 02, 2020

People who know a little about the history of our firm sometimes credit us with being ahead of our time. When we set out 30+ years ago we made an early decision that we would only invest in stocks of high-quality companies capable of growing revenues and cash flows over long periods of time, and then only when we could purchase them at reasonable prices. Mind you, this was two years before Eugene Fama and Kenneth French proposed their three-factor model incorporating value, and more than a decade before Cliff Asness’s seminal work on quality or the conflicting studies on the long-term premium provided by growth. So, we weren’t thinking of these aspects of our process as “factors,” or permanent sources of returns, in the current sense of the term. We thought they were merely sensible principles, based on our own beliefs about the markets, that would give us the best chance of achieving the above-market returns necessary to satisfy our clients and sustain our fledgling enterprise. Considering we had left well-paying jobs to stake our futures on these ideas, there were probably some people who thought us out of our minds. And, in a sense, they were right.

Value: Patience as a Virtue

Though we are frequently characterized today as “quality growth” investors, the truth is we started from a place of focusing on value. We have always believed that, as Warren Buffet put it, “price is what you pay; value is what you get.” We also recognize that, while the two converge over time, it is impossible to predict when that convergence may occur. Over the years other value-focused investors have come up with various ways of coping with this unpredictability. Some implement value strategies by timing their purchases so there is not only a share price that implies a discount to underlying value, but also a “catalyst” to accelerate that convergence. Another group, among them followers of the father of value investing, Ben Graham, effectively puts a cap on their patience. They buy stocks trading at a discount to value, but if price and value haven’t converged after some period, they move on to another investment. We were young, figured we had time to wait, and saw no need to identify catalysts or impose a time limit for estimated values to materialize in current market prices.

Growth: In Case We Were Wrong

Investment managers with our very fundamental, bottom-up approach to investing spend much effort determining what a share in a company is worth. That entails thinking about a company’s addressable market, market share, the relative power of its suppliers and customers, volumes, prices, and margins, and making forecasts of those variables, and others, many years into the future. Given that we don’t know what will happen tomorrow, let alone several thousand tomorrows from now, these forecasts are never going to be terribly accurate. Once we translate our forecasts into estimates of the company’s future cash flows, we discount those cash flows to a present value using a discount rate. What that discount rate should be is also highly uncertain. At the end of the day, we gain a rough idea of what a share in a company is worth, but one subject to a very large margin of error.

Cash flows are hard to forecast and future discount rates completely unpredictable. But we figured that if the valuation at purchase was too high and didn’t rise, if at least we had growth the investment would still generate a positive return.

We liked prospective growth because it can bail us out of those forecasting errors. When we buy a stock, the return we achieve over time will be a function of changes in estimates of its value (i.e., its earnings multiple) and in the growth of its earnings. Changes in the multiple come about through changes in estimates of future cash flows and, if not more important, changes in the rate at which you discount those cash flows. Cash flows are hard to forecast and future discount rates completely unpredictable. But we figured that if the valuation at purchase was too high and didn’t rise, if at least we had growth the investment would still generate a positive return.

Quality: The Element of Positive Surprise

Quality came into the process mainly as the way to control risk and boost our odds of success. Quality is related to growth in that a higher-quality company is more likely to make high levels of returns on its capital investments, and to have more growth opportunities in which to invest the cash it generates. But quality is also about financial strength and avoiding the risk of having to rely on a balance sheet that can’t withstand the vagaries of the economy, product cycles, or waves of competitive pressure. Finally, it’s about the ability of management to see opportunities and threats, and to deliver to shareholders the expected returns on growth opportunities.

Ideally, a company will exhibit a track record of such patterns and behaviors that extends across successive management teams—evidence of an enduring company culture that is hard to measure objectively but can lend some degree of confidence to our forecasts amid all the uncertainty. A high-quality company, in other words, is one which will tend to give us pleasant surprises. While we realized we would nearly always be wrong, outcomes can be better than forecast as well as worse. By focusing on high-quality companies, we believed we could skew the distribution of our surprises in the positive, not negative, direction.

Out of Our Minds

Thirty years later, our process has become more structured and systematic, and our methods more refined, but the essential relationship among the core aspects of our investment principles remains very much the same. So has our approach to tackling the intellectual challenges with which we wrestle to this day. Now, as then, we subscribe to a belief that it’s always better to get our thought processes, ideas, arguments, and however-partially baked notions out of our own heads and onto a page, where we are more accountable for them and others can help us make them better. We hope you’ll start looking to this space for more of what comes out of our minds.

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Don’t Just Do Something—Stand There

By Simon Hallett, Vice Chairman | May 26, 2021

Humans prefer to do something rather than nothing. We like office environments that are a “hive of activity” and commend “men of action.” When stuck in a traffic jam, we will take an alternate route just to keep moving, even if it prolongs the journey. We tend, though, to conflate activity with productivity, mistaking the people whom we see doing the most with those who are the most valuable.

We see this bias in many domains. Our political leaders tend to respond to a crisis with ill-considered policies that capture attention but often do little good and may even do harm. It would be unacceptable for them to stand by and simply do nothing. While serving as both vice chairman of Harding Loevner and as chairman of a professional soccer club that competes in the English Football League (EFL), I have been struck by the parallels between investing and sports when it comes to the biases that damage effective decision-making. Studies have looked at penalty kicks in soccer. When a penalty is awarded, the ball is placed 12 yards from the center of the goal and a kicker gets the opportunity to score with only the goalkeeper standing in the way. It turns out that because of the goalkeeper’s bias for action, the optimal place to kick the ball is directly at the center of the goal. A goalkeeper will almost always dive one way or another in anticipation. If he dives the wrong way, he’s forgiven as having simply guessed wrong, or as being sent the wrong way by the kicker’s supposed feint. If he dives the right way, he has a chance to stop the ball entering the goal. If he merely stands in the middle, however, he is the subject of much abuse for doing nothing.

Investors fall victim to similar pressures and impulses. The immediate costs of transacting are low, and the propensity to transact is high. The result is that investors transact too much, and their returns suffer. They tend to transact at the wrong time, buying after prices have risen, and selling after prices have fallen.

Underlying these behaviors is a general misunderstanding of the roles of luck and skill. In sports and in investing, short-term results are the outcome of a combination of the two. Yet, we tend both to attribute the outcome more to skill than to luck and to extrapolate a series of outcomes (good or bad) into the future. This tendency stems from our deep-seated need for explanation, and a need to feel we are in control even when we are not. This occurs particularly in those sports, like soccer, that are generally low-scoring affairs. Unlike in basketball, for example, where there will be more than a hundred points in a game, the average number of goals in a professional soccer game is roughly three. The result of a single game will largely be driven by luck—one bobble of the ball, the inches between hitting a goalpost and scoring, a poor refereeing decision. Yet the narrative in post-match interviews is seldom “we got lucky.” At least, it’s seldom the case that “we got lucky” when the interviewee’s team wins. When the team loses, the loss is the result of bad luck! How similar this is to investment narratives, where there seems to be only two kinds of investment managers: the talented, and the unlucky.

Benevento,Italy,,February,4,,2018:,Lorenzo,Insigne,Of,Napoli,Hits

At my own club, last season, we had a pair of games scheduled close together. In the first, we gave up a 1-0 lead late on and ended up with a tied game. In the second, we scored a late goal from an unexpected source to win 1-0. The narrative of the first was that “we didn’t know how to hold a lead,” and of the second that “we were gutsy and played to the end.” Same team, same players, both close games, but different outcomes drove radical differences in explanation.

As in investing, in sports a series of poor results needs a narrative to explain it, and action to reverse it. Often that action is to replace the coach. Acting to replace him when results go the wrong way attributes far too much causality to the coach. George Steinbrenner famously hired Billy Martin five times as coach of the New York Yankees. Between the Premier League and the three levels of the EFL, more than half of the 92 clubs replaced their manager this season alone. Replacing a manager tends to come at considerable cost—he (it’s always he) will have his own preferences for players and staff, and perhaps may even want to change the style of play completely—with little evidence that the players who actually kick the ball around improve their own performances as a result. Because luck occurs randomly while skill is reasonably constant, after teams are unlucky for a stretch their luck will tend to mean revert. The “manager bounce” is a well-established phenomenon whereby short-term results usually improve after a manager is replaced. It is a statistical phenomenon, though, that has little to do with on-the-pitch performance.

For asset owners, there is a similar temptation to replace a manager after a period when returns have disappointed, but, alas, unlike the fans of a soccer club, the clients of an investment manager do not enjoy the mean-reverting returns that the manager provides those who stuck with them.

For asset owners, there is a similar temptation to replace an investment manager after a period when returns have disappointed. But, alas, unlike the loyal fans of a soccer club, the former clients of an investment manager do not enjoy the mean-reverting returns that the manager provides those who stuck with them. There is plenty of evidence that investors’ urge to act is damaging to their long-term returns. In mutual funds, on average, dollar-weighted returns that shareholders receive from their funds lag the time-weighted returns that the funds generate. This “behavior gap” is directly the result of poorly timed action on the part of shareholders.

Incentives and market structures only make the bias toward action greater. One reason that English soccer coaches get changed is that, once the season starts, players may not be traded outside the month of January. A result is that during the January transfer window it’s almost non-stop activity. The period has become its own media event, with fans, players’ agents, and media pundits all calling for teams to make their moves. This, even though only a few such moves ever have significant impact on a team’s results, and despite evidence that prices paid for players tend to be higher than between seasons.

The investing industry has many incentives to transact; indeed, the revenue models of many participants depend on transactions taking place. When I started in investment management, in London in the late 1970s, our fees were not based on assets managed as is the case today. We were paid when we made a transaction in our clients’ discretionary portfolios. Why is the portfolio turnover of the average equity mutual fund so high, when doing nothing and allowing returns to compound over prolonged periods of time is often a superior way to generate market-beating returns? It’s because the investment industry exploits clients’ bias in favor of action. Managers’ actions are described in emotional terms. We read of “conviction,” of “exciting opportunities” and “story stocks.” The reality is more mundane. Successful investing is about resisting the urge and the calls to action, knowing when to sit on your hands and do absolutely zilch.

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Culture Club

By Simon Hallett, Vice Chairman | October 06, 2021

In sports, dynasties like the American football Packers of the 1960s, the New Zealand All Blacks national rugby squad, and basketball’s San Antonio Spurs have demonstrated the power of culture to bind individuals together and enable a team to produce results above what could be expected by simply adding up the expected contributions of each member. The business world has tried to produce similar results; although exactly what culture is remains poorly defined, the hundreds of jobs available on LinkedIn seeking an individual to oversee a company’s culture certainly attest to its importance. I’ve been fortunate to have a front row seat at an investment firm (Harding Loevner) known for its strong culture and, more recently, at a UK football club (Plymouth Argyle) that is trying to develop a culture that will strengthen the organization behind the team on the pitch. As is frequently the case because of my dual roles, the parallels between the two industries and the two organizations are very much on my mind.

There are many similarities between cultures at football clubs and investment organizations, despite the underlying processes required by their core activities—making decisions on the pitch about how to try and score and defend or making decisions about buying and selling securities—being very different.

In both industries, the goal is for the team to be greater than the sum of its parts. On the pitch, an individual must rely on teammates, but certainly not debate or challenge them. Rather, coaches teach decision making so that, like muscle memory, it is instantaneous and requires little active thought.

At Harding Loevner, rules and processes constrain decision making to prevent it from being dominated by cognitive biases. Colleagues think for themselves but must expose their ideas to challenge. This is the core of our investment culture—what we call “collaboration without consensus.” We believe that one of the most difficult biases to overcome in conducting research is the tendency to give precedence to evidence that confirms our beliefs and to ignore evidence that challenges them. So, it is important that our ideas be continuously exposed to challenge. However, this leads to other problems. Humans, as social beings, generally don’t like disagreement; they are literally fearful of it. That’s why an important part of a culture of collaboration without consensus is that it be enabled by both transparency and the value of tolerance. We strive to sustain an environment in which colleagues do not feel threatened by disagreement and recognize that challenges—while discomfiting—are essential for good decision making.

It would be nice to be able to say that our culture at Harding Loevner emerged from a successfully executed plan, but that wasn’t really the case. Thirty-plus years ago, the few of us at the firm just wanted to be good investors and to serve clients who shared our views about what made a successful investment program. The firm’s values simply reflected the personal values of the founding generation. We all believed strongly in acting with integrity and always putting clients’ interests first. Beyond that, I don’t think you could say we particularly held the values associated today with Harding Loevner. We didn’t set out consciously to make a culture based on transparency, personal accountability, tolerance, and the importance of process. Those values only developed as we learned more about decision making, often from our mistakes.

For example, we discovered early on that sharing information with our colleagues was valuable in sharpening our views. But we soon learned that without individual accountability and very clear rules of engagement, disagreements could very easily descend into finger-pointing and personal attacks. We also came to realize that no amount of experience is a substitute for exercising judgement within the constraints of process and structure. The alternative, too often, is a culture of blame and chaos.

Left to Themselves, Even Great Cultures Die

Part of a winning culture is the ability to adapt to changing circumstances, to have processes that change, and to take risks with new ways of behaving. Above all, perhaps, is the willingness to keep learning. Arie de Geus, former head of Royal Dutch Shell’s Strategic Planning group once said, “In the future, the ability to learn faster than competitors may be the only sustainable competitive advantage.” That ability must be embedded in culture no matter what other values the culture incorporates. A good example comes from the success and subsequent decline of Arsenal Football Club, which in the late 1990s broke with English football tradition by hiring a Frenchman to manage the team. Arsène Wenger’s on-the-pitch tactics and approach to nutrition and training overturned decades of English football culture and brought a level of domination rarely seen in professional sports. The Arsenal team of 2003-4 was unbeaten during an entire season, a feat that had not been accomplished since the late nineteenth century. Although the club went on to further success, other clubs gradually learned from, adopted, and refined its methods. Arsenal failed to innovate further and gradually slipped down the league table to a point where Wenger was eventually replaced.

Arsenal's (L to R) Kolo Toure, Robert Pi

The 2003-2004 Arsenal team earned the nickname the “Unvanquished” for becoming the first elite-level UK football club in more than 100 years to go an entire season undefeated—in large part thanks to its disruptive culture. Above, Kolo Toure, Robert Pires, and Ashley Cole celebrate the 2-2 tie with Tottenham that sealed the feat.

Source: ODD ANDERSEN / Staff via Getty Images

As we endeavor to strengthen Plymouth Argyle’s culture, my experience at Harding Loevner has been critical in giving me a clearer sense of what will work. At Harding Loevner, we were taking cautious steps in the dark, with nothing to give us confidence that we were on the right path. But we did learn, and that has been helpful as we try to make an Argyle culture that will enable us to achieve our vision. As such, we are approaching our task with an intentionality that would have felt presumptuous to my younger self. It starts with a more specific goal. English football is a multi-level pyramid in which especially good or poor performance brings promotion or relegation to the next level up or down in the hierarchy. At the end of 2019, a year after we had lost our spot in League One (the third level from the top), we said that in five years our goal was to be financially sustainable and playing two levels above where we were then.

To realize that vision, one of the key values we have espoused at Argyle, just as at Harding Loevner, is transparency. One difference is that our transparency extends to writing down our Vision & Values and posting them to our website. In this way, everyone at the club—as well as our supporters and sponsors—knows what the vision is and what the values are that we expect will underlie every decision. Another of our core organizational values is to be efficient and process oriented. Here, again, we are not exactly inventing the wheel. Increasingly the lessons those of us in finance and organizational science took to heart about the role of process in managing our cognitive biases have also found their way into successful sports cultures. The most famous example comes from baseball where the Oakland A’s, under general manager Billy Beane, incorporated objective data into their decision-making processes to come up with new ways to gain competitive advantage on a limited budget. Once it was widely revealed in Michael Lewis’s Moneyball, Beane’s approach influenced most of the rest of baseball, spread to basketball, and is now beginning to have an impact on English football. At Argyle, our most immediate source of inspiration has been the outrageous success of Brentford F.C., for years a lower-league club of modest means, which, under the ownership and guidance of Matthew Benham (who made his fortune successfully managing his own cognitive biases gambling on football matches) has risen to the English Premier League, the pinnacle of the football pyramid.

I could elaborate on how these and our other values trickle down via our areas of strategic focus to Argyle’s CEO’s goals and to the goals he sets for every individual. But for my purposes here, the point is just that these values and goals are written down, enabling the board to communicate to our fans how we will behave and to our staff what we ask of them. The result has been powerful. Two years into our five-year plan, we have regained our position in League One, halfway toward our goal of climbing to within a level of the overachievers at Brentford. More importantly, everyone at Argyle now knows what we are trying to achieve, what is expected of them, and the values that should underly their everyday decisions.

We are now at that critical juncture faced by any strong culture looking to endure and thrive through generational succession.

I’ve learned from Harding Loevner the kind of culture that leads to sustained success. I’ve learned from Plymouth Argyle how impactful transparency and communication can be in cultivating that culture. Harding Loevner has reached the age where it can no longer rely on the people who made up the founding generation as its cultural torchbearers. Over a decade ago, we began laying groundwork for the transition of ownership and management of the firm from that generation to the next. We are now at that critical juncture faced by any strong culture looking to endure and thrive through generational succession. As the people in whom the culture is most embodied prepare inevitably to move on, they have no choice but to write more of it down. We early settlers will need to be more transparent (at the risk of being annoying) about what our culture has meant to us personally and to the firm’s success under our leadership—not so that it may be set in stone to be accepted immutably, but that it may be evaluated critically. Our younger colleagues may have slightly different beliefs and values. We expect them to receive the vision, turn it over in their minds and revise it so that they may carry it on as their own. It will be their responsibility to make sure that the firm’s culture enables it to serve its clients as well in future as it has since 1989.

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Out of Our Minds

Informational

Analytic

Decision-Making

Organizational

Out of Our Minds—From the Beginning

Value: Patience as a Virtue

Growth: In Case We Were Wrong

Quality: The Element of Positive Surprise

Out of Our Minds

Don’t Just Do Something—Stand There

Culture Club

Left to Themselves, Even Great Cultures Die

Source: ODD ANDERSEN / Staff via Getty Images

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