“Research is a quest for truth, not a confirmation of predetermined beliefs that we have concluded to be true. It must be conducted without an agenda. You should not care what truth will be revealed, as long as your process reveals the truth. Investors who go about their research to validate a preset conclusion are doomed to fall into the confirmation trap.”
— Rupal J. Bhansali, Non-Consensus Investing, p. 175
In Garrison Keillor’s fictional Lake Wobegon, “all the women are strong, all the men are good-looking, and all the children are above average.” We chuckle at the absurdity of the notion that an entire population can somehow be “above average” because, of course, this is not possible. Yet what is sometimes known as the Lake Wobegon Effect is alive and well in many facets of life.
Most drivers are convinced that they are well above average. A recent survey revealed that ninety percent of parents think that their child is above average. These types of misconceptions are known as illusory superiority, a cognitive bias that impacts many aspects of human life. We know that the vast majority of other people must, by definition, cluster near average, but we most certainly are not part of that run-of-the-mill group.
One of the reasons that people fall victim to illusory superiority is because human beings have an innate need to feel good about themselves. No one wants to believe that they are average or below average, especially in an area that they closely associate with their personal or professional identity. Maslow’s Hierarchy of Needs places self-esteem fairly high up on the pyramid and it is definitely a prerequisite for happiness. Almost everyone wants to be respected by others and, even more importantly, wants to achieve a certain degree of self-respect. No one has any desire to view themselves as inferior or incompetent.
The Hollywood stereotype of Wall Street would lead outsiders to believe that traders and investors are hyper-confident people certain of their ability to compete and win. Sometimes Hollywood stereotypes are not that far from the mark because it is rare to meet an investment professional who projects any hint that he or she is anywhere near average. After all, the role of active investment management is to compete, win, and significantly outperform the averages. An investor who is not able to prove above average skills will not be able to justify management fees and will eventually be out of a job.
While the need to outperform, and consequently to have high self-esteem, is ever present, we should bear in mind that human beings have even more fundamental needs related to safety and belonging. In the field of investing, it is very common for professional investors to cluster around commonly held beliefs and ideas because it is much more comfortable to be in agreement with others than to offer divergent views in opposition to the best loved beliefs of your peers. If you fail on Wall Street, it is much better to fail conventionally with everyone else than to take divergent non-consensus views and fail unconventionally. This leads the vast majority of investors to take on consensus views most of the time and results in dysfunctional behavior such as closet indexing that fails to add any long term value.
Rupal Bhansali advocates a far different path for active management in her new book, Non-Consensus Investing: Being Right When Everyone Else Is Wrong. While not against passive investing per se, Ms. Bhansali believes that there is a far better approach that makes it possible to do what academic theory argues is impossible: increasing returns while lowering risk. We all want to outperform passive indexes and any investor who has been around through multiple market cycles is aware of the need to contain risk. The ability to construct a portfolio of investments that outperform the market and carry a lower risk of permanent loss of capital could be viewed as the holy grail of investing. However, unlike a quest for an ancient relic, there are well understood principles that increase the probability of achieving the holy grail of investing. This book presents Ms. Bhansali’s approach to escaping the average and achieving meaningful outperformance.
Active vs. Passive
The fact is that any investor has the ability to match the market by using index funds. John Bogle, the inventor of the modern index mutual fund, was a relentless crusader for giving ordinary investors the ability to at least match market returns. Active management holds out the promise of either achieving market returns with demonstrably lower business risk or exceeding market returns without taking on much higher risk (or, better yet, taking less risk). At the time of Ms. Bhansali’s writing in November 2018, index funds had nearly reached fifty percent of U.S. stock fund assets. Passive index funds went on to exceed active funds based on assets under management in September 2019.
Ms. Bhansali believes that passive investing is becoming a “crowded trade” due to its amazing success in attracting assets in recent decades. She believes that this dominance has caused a number of risks to build up that are not commonly understood. Furthermore, she believes that the overall valuation level of stocks at the current time make it likely that passive strategies will provide only paltry returns in the future that will be insufficient for individuals and institutions that require greater returns.
Just because investors may “need” higher returns does not mean that the markets will give it to them, but Ms. Bhansali believes that it is important to invest actively in order to have a reasonable shot at decent returns in the years to come. One reason active strategies may become more viable in the future is that index funds could be causing various types of market inefficiency due to the mandate these funds have to own securities regardless of valuation. Active managers can monitor management behavior and hold their “feet to the fire”, and the actions of such managers increase market efficiency. In recent years, activist investors have done much to improve the operations of specific companies. The incentive to do this was to achieve outperformance. It is difficult to imagine even very large passive investors taking on activist roles and pressuring management because they have no incentives to do so – they are simply paid to match an index, not to improve returns.
The Ability to Stand Apart
Many investors confuse voluminous knowledge of facts and figures with differentiated insight. The problem is that merely knowing all the information about an industry or company does not provide a meaningful edge over other market participants, especially in the case of crowded trades.
“Markets do not reward research that discovers or proves what others have already discovered or proven. All the midnight oil burnt; frequent flyer miles logged; and arduous meetings with management, suppliers, customers, and competitors to conduct fundamental research amounts to zilch if you do not uncover anything new or different. Active investors who are unskilled in their research efforts are rightly facing an existential wake-up call: differentiate or die. It is not a market conspiracy but a market objective to weed out such undifferentiated active investors who add transaction costs in the form of high fees for their efforts but generate no value.”Non-Consensus Investing, p. 45
Ms. Bhansali correctly observes that an investor must first be a business analyst and then a financial analyst. Many investors get this backwards. They seek to know every data point about a business but they do not go beneath the numbers to identify why a company has been successful or has run into trouble. Understanding financial data points is necessary to make good investment decisions but it is not sufficient.
BlackBerry and Apple
One of many brief case studies in the book involves the story of Research in Motion, the company behind the wildly popular BlackBerry device. Millennials may have only the vaguest memories of BlackBerry, but those of us in the business world during the first decade of the century recall what a cult following these devices had. They were must-have accessories because the reliability and security of BlackBerry was unmatched and there were no real substitutes.
Those who focused only on data points found the RIM story fantastic. The stock was roughly a 100-bagger over a span of less than six years through mid 2008. However, improvements in cellular networks, competing technology, and the emergence of smart phones made BlackBerry’s competitive advantages irrelevant. Investors who focused only on facts and figures did not act as business analysts. The question of why metrics such as profit margin and market share were high was not asked by many investors until it was too late.
Could investors have identified risks in the BlackBerry story early enough to escape the carnage in the stock that took place once the handwriting was on the wall? The book contains a number of questions that enterprising investors should be asking to get behind the numbers and understand the underlying drivers of the business. In particular, Ms. Bhansali provides a number of “myths and truths” about quality that can help investors differentiate between the real thing and value traps.
Will Apple’s cult-like following and seemingly impregnable moat be disrupted in a manner reminiscent of BlackBerry? This has been on the minds of many investors lately, especially as Apple shares have reached new record highs taking the market capitalization of the company to nearly $1.2 trillion in November 2019. Ms. Bhansali looked at the company in the 2017-2018 timeframe and came away unimpressed for a number of reasons. She views Apple as a mature consumer electronics company with single-product risk due to continued heavy reliance on the iPhone. Although the average selling price of new iPhones has been increasing in recent years, the frequency of replacement has declined and developed markets appear to be saturated while Apple has little to offer emerging market consumers at a price point they can afford.
Ms. Bhansali is not overly impressed with the pivot toward services revenue because the driver for such revenue continues to be correlated to the number of devices that are sold. If the installed base of iPhones shrinks, so would service revenue opportunities and she worries that this could cause Apple to become a melting ice cube. Importantly, she points out that there is no need for Apple to fail in order for investors to get hurt. All it would take to cause a significant fall in the stock price would be a moderate revenue decline coupled with declining margins. The resulting lower earnings would break the growth story and likely cause the earnings multiple to decline.
Of course, Ms. Bhansali may or may not be correct about Apple’s prospects. Obviously Warren Buffett would strongly disagree with this assessment! The important point, however, is that Ms. Bhansali is focusing on business drivers that are behind the reported numbers. She is asking the ever-important “why” questions regarding Apple’s current dominant position and attempting to formulate a non-consensus view.
One of Apple’s most successful advertising campaigns was a celebration of people who “think different”. There might be safety in numbers and warmth in the middle of the herd, but those who seek to be an exception in any field of human endeavor must strive to be different in some way. Of course, the risk of being different but wrong is ever present. Being different is not a guarantee for success, but following the herd implies guaranteed mediocrity.
Ms. Bhansali urges active investors to “think different”, to dare to buck the comfortable consensus and come up with differentiated insights that have a chance of generating outperformance. Her book provides a number of valuable insights regarding how to go about the research process in a way that is likely to uncover non-consensus views and, even more importantly, how to control risk and avoid common traps. A healthy degree of self-confidence is essential for accomplishing any of this in the field of investing, but the same is really true in any field.
So … Active or Passive?
Should investors who lack either the interest or capability to implement a non-consensus strategy adopt a passive approach or look for a manager who has what it takes to outperform? Ms. Bhansali believes that the passive approach is unlikely to deliver the kind of returns that most investors need in the years to come. But is it possible to identify managers who can deliver better returns in advance? There is no doubt that such managers exist, but we do not know whether the successful managers of the past will be successful in the future. The risk is that one picks an active manager who goes on to underperform. If that happens, the paltry returns on offer from a passive strategy might seem desirable in comparison.
My own non-consensus view is that the vast majority of Americans would be best served by lowering their expectations and doing so with equanimity. The American household earning the median income lives a lifestyle that an American living a century ago would look upon with amazement and envy. Those of us with greater resources are even more fortunate, but still rarely satisfied. The problem is that the hedonic treadmill leads people to never be satisfied with what they have. To some degree, the quest for an ever-improving life is the American way, but this can be taken to excess and can lead to unhappiness. Most people would do well to lower their consumption, increase their savings rate, and dollar cost average into broad based index funds over a long lifetime. In fact, Warren Buffett, the greatest investor of the past seventy years, suggests that people should do exactly that.
Disclosure: The Rational Walk LLC received a review copy of this book from the publisher.