If you are anything like me you will have arrived in January willing yourself to be a better person, full of resolutions to eat less, exercise more, and to use your time more wisely. As we all know it is much easier to plan to do this, than to actually do it! At every twist and turn temptation lures you down the alternative path. My personal nemesis is dark chocolate. Put a bar of it within a hundred feet of me and I turn into Augustus Gloop, shoveling it down as if I hadn’t eaten for a week. Now of course I know that my body would be better served by time on the treadmill, but my inner chimp is somehow blind to this in the moment that temptation strikes.
The reason we struggle to stick to our resolutions is that the “good stuff” invariably gives us a dopamine hit that we are evolved to desire. My pre-historic ancestors didn’t have to contend with a Hotel Chocolat outlet on every street corner, and with limited supply it made sense to indulge whenever the opportunity arose.
When you view the world through the lens of dopamine hits, you realise that many highly profitable businesses are built on our inability to suppress desire. Tobacco, alcohol, and sugar are all tangible examples that have spawned lucrative multi-trillion-dollar industries. Some other examples I can think of are perhaps less suited to a family audience!
Human ingenuity, being what it is, has increased the variety of ways that we can get our kicks, and made them more copious. Digital technology took this to another level, with social media platforms being examples of mighty businesses created in the knowledge of what makes our inner chimp tick. Search for a video of a cat, and Google will provide you with 466 million different choices. You could watch them for the rest of your days, without need for repetition.
Before you start thinking that I am subjecting you to a treatise[1] on healthy living, I will return my narrative to investment management.
In much the same way that our personal indulgences stimulate dopamine in our brains, many of the forces acting on us as professional investors do too. We are subject to a virtual firehose of information, analysis, and punditry that has been growing in size exponentially. The quest for our attention nudges much of this content away from the mundane and into the direction of the titillating or sensational.
I am a firm believer that most of what provides excitement in financial markets is irrelevant to the discipline of investing. Focusing on where the latest inflation “print” landed, which companies had a quarterly earnings “miss”, or what Elon Musk tweeted, directs attention towards the short-term and overestimates the importance of what is often just background noise. This in turn can lead to the “churning” of investments, which wastes money on transaction costs, and makes one more likely to crystallise loses and miss gains.
With all of this said, I like this status quo, because the fixation on the short-term creates miss-pricings that value investors, like us, can benefit from!
An example of this is an industrial business that we just added into the portfolio. It is a key supplier in the food chain, has served customers since 1842, and is the number two operator amongst four dominant suppliers. It has a number of barriers to entry, but its apparent downfall is that customer orders ebb and flow with the price of commodities, such that its economics are “cyclical”.
A recent broker note on this company argued that an 8x earnings multiple was a fair way to estimate the value of the business, versus the current share price being at 6.8x. I happen to think that it is a bargain, but this isn’t the point of the story. In the analyst’s mind uncertainty over the price of soyabeans next year seems to hold far more importance than 150 years of history. Judging the company as being worth only 8x earnings, suggests a very bleak outlook. That this analysis didn’t attempt to discuss the longer-term, tells me a lot.
I see a long-term focus as a key source of investment edge for us, but one that requires daily effort to maintain. The drumbeat in markets is focused on the short-term, and rushing to buy or sell investments on the back of it does, I believe, stimulate dopamine in the brain. Much has been written on the subject of behavioural finance, and our chimp brains bias towards activity is well documented. Warren Buffett summed this up well when he said that “the stock market is designed to transfer money from the active to the patient”.
The ugly twin of short-termism, is narratives. Our brains work best with stories, which is why much of what we read about markets takes this form. Pundits attempt to rationalise every up or down move in each financial instrument with a story as to why people were buying or selling. Narratives are what lends credibility to a focus on the short-term, as they make investors feel more confident about the certainty of the risks and opportunities they face.
Clearly some narratives will be accurate some of the time, but often they are pure conjectures. Our approach to investing is to be circumspect about accepting any explanation at face value, unless we can substantiate it. It helps to be able to hold multiple competing narratives[2] in your head at one time, but this is easier said than done, and is a source of discomfort. When you are less willing to accept a narrative, you are less inclined to knee-jerk reactions.
An area where we were actively investing last year was in UK mid-caps. Much ink has been spilt crafting narratives as to why they appear cheap, often rationalising it as a logical consequence of concerns about the British economy. Likewise, explanations as to why individual companies see their share prices fall, typically focus on the nuances of the outlook for their business.
We met the CEO of a FTSE 250 company which is priced around 7x next year’s earnings, suggesting major concerns about its longevity. It is an international business, being one of two dominant global players in their field. The CEO told us that many of their large shareholders were UK focused funds that had suffered large redemptions, which had caused them to be forced sellers of their holdings. Whilst this is a narrative, it is an alternative to the idea that investors are acting purely based on views of company fundamentals.
I mention this as I see the fall in valuation of many UK listed companies as an example of how a fixation on narratives by others is creating opportunity for us. Whilst the uncertainty of BREXIT was a legitimate reason for concern over domestically focused companies, it appears to have given way to a stampede of indiscriminate selling of UK listed assets. This is evident from the number of UK focused funds that have seen major redemptions.
We of course do not know when, if ever, the abandonment of the UK equity market will reverse, but the sale of Hotel Chocolat to Mars, provides an example of how counteracting forces can work.
Much like New Year’s resolutions, I think many investors know the right thing to do if they are to achieve improved financial health, but the hard part is to actually do it. I will be doing my best to stay away from dark chocolate this year, but I don’t suppose it will cause Mars to rescind their offer!
[1] If this is what you were looking for, I can highly recommend Anna Lembke’s book, “Dopamine Nation”.
[2] This is a concept recognised by psychologists and known as cognitive dissonance.