Friday, June 19, 2009

Less (hindsight) is more (profit)

This is the third article in our series on Investor Psychology. It is loosely based on research done by Daniel Kahneman (Ph.D) who published "Aspects on Investor Psychology" in 1998 as well as other interesting finds on the subject.
It is well documented that people can rarely reconstruct what they thought was going to happen just before the event occurred. Most people exaggerate their earlier estimate of the probability that an event may occur. This manifestation is called hindsight biases.
Have you ever noticed how financial experts can be heard on the radio each day, after the stock market closed, explaining (with high confidence) why the market reacted in a certain way? You, as a listener, could well draw the conclusion that the behaviour of the market was so obvious, that you should have (or could have) predicted it earlier.
Hindsight errors are harmful in two ways. Firstly, hindsight promotes over confidence – fostering the illusion that the world is a more predictable place than it is. Secondly, hindsight often turns reasonable gambles into foolish mistakes in the mind of the investor. After the price of a share lost 30%, the drop appears to have been inevitable – so why did you not sell earlier?
Hindsight is an important element of investors regret and an unfortunate fact of life. However, even with the benefit of hindsight, you still run the risk of being wrong.
Consider this article written in January 2008 by Simon Marais (former Chief Investor for Allan Gray, and now working for an Australian sister fund - Orbis). He starts by describing a different approach to their (Allan Gray and Orbis) style of investing.
"I'm afraid our quarterly reports often do not make for exciting reading. We like to delve into mundane details about obscure companies that only financial analysts can find interesting. We seldom have the popular eye-popping graphs about building statistics in China or India, the latest technology trends or exclusive interviews with central bankers. It is certainly much more fun to tour China or India or visit the latest technology trade show than to read the small print in a set of accounts. But we think that it is very hard to make money off macroeconomic analysis. Forecasting is notoriously unreliable, specially where large trends are involved."
Here he already hints that macro economic trends, forecasts and analysis are of little use to an investor. He goes on two compare two well-known industries: Technology and Tobacco
"We asked ourselves what area of the market has shown the best growth to date and which part experienced the most headwinds. With perfect hindsight, our conclusion has been that computers and development in IT technology have exceeded even the highest expectations 35 years ago. The worst industry since then has probably been tobacco. In 1973, smoking was still common on airplanes and you would certainly be classified as highly eccentric at best if you told someone that they had to smoke outside."
Now you can ask yourself – for the next 30 years, which industry would yield the highest profit?
"Armed with this knowledge, you would think making money (at least in a relative sense) would be easy. Buy the dominant companies in the computer/IT industry and avoid companies selling tobacco. Back then, IBM dominated the computer space, while the largest tobacco company was Philip Morris (now called Altria)."
The following graph show the value of $100 invested in 1973 in both stocks with all dividends re-invested.

" A $100 investment in IBM has grown to $1,700 by the end of 2007 – a little better than inflation, but worse than the general stock market which yielded $3,500. Your hindsight on the IT sector has certainly not been any help. But an investment in Philip Morris/Altria has increased to $35,000 – 20 times more than the IBM investment and 10 times more than the stockmarket."
I other words, if you assumed that IT would expand rapidly and tobacco be banned, and that be reflected in your investment, you would have been wrong. What about the second largest companies at that time in the respective industries?
"The second largest computer company of the day was Digital Equipment which was taken over by Compaq 10 years ago for less than four times its 1973 price. You have to look carefully to distinguish Digital Equipment's graph from the bottom axis. British American Tobacco, the second largest tobacco company at the time, was up 1,000 times."
Simon Marais argues that even with the benefit with hindsight, forecasts are of little value to the investor.
"Not only was perfect foresight in macro-economic matters of no value, in fact it actively led you to make poor investments."
He then tries to explain (just like the above mentioned radio commentator) why this happened and by doing so, he confirms the prediction by Kahneman that the fascination with interpretations of the past persist. If you read the explanation, it all makes perfect sense.
"We believe this to be one of the most underappreciated facts about financial market research – it is not only the growth in your markets that is important, but even more so is the growth in competition that you face and this is the part that is very difficult, if not impossible, to predict. The computer industry experienced rapid growth, but that spawned massive competition and constant innovation. The large incumbents of the day not only had to fight many existing competitors for their market, but completely new competitors arose – Apple, Microsoft, Dell, Google – that had business models that a large incumbent found difficult to emulate.
At the same time, the tobacco industry has faced a shrinking market, rising taxes, a ban on advertising and a series of huge lawsuits. However, nobody entered the market and the incumbents could pass all costs (plus some) on to their customers and with no re-investment needs all profits could flow to investors as dividends."
However, Simon Marais does not fall into the trap of explaining the past without concluding something significant. To make money and to be a successful investor, he conclude, is to not follow the trends, the crowds or the next big thing. In other words, not sticking to hindsight
"So unfortunately our conclusion is that to make money for your fund, it does not help to take trips to exotic locations or to mix with the high and mighty. Rather, profits are made by a detailed study of companies where other investors have often written them off because they dislike the industry or find it to be "boring". History teaches us that exciting industries attract competition from unexpected places and have a high chance of being poor investments. In contrast, "boring" industries tend to lead to a decline in competition and turn out much better than macro analysts might have expected."